HE purpose of this paper is to analyze the behavior of the Japanese trade balance for the period of 1966-80 using a conventional elasticities approach. However, unlike previous works in this area, our approach emphasizes the following key features of Japan's foreign trade: (a) almost all exports (more than 95% in 1975) are manufactured goods: (b) except for foods (15.2% of imports) imports are either used as inputs in the manufacturing sector or manufactured goods which compete with home products. Consequently, by concentrating on the behavior of the manufacturing sector, we can explain most of the components of exports and imports. In view of this we estimate a model of the manufacturing sector in which firms in the sector use imported fuels and raw materials as inputs and produce outputs sold in both foreign and domestic markets. The demand for fuels and raw materials and the supplies of output (or output prices) in the domestic and foreign markets are all derived from a profit maximizing behavior of the manufacturing sector. Thus, imports of fuels and raw materials are treated as derived demands. The most important advantage of such an approach is that we shed light on interactions between domestic and foreign markets on the one hand, and between exports and imports, on the other. This is in sharp contrast to the traditional demand-for-imports-supply-of-exports approach which estimates each component of the trade balance separately. Another advantage of our approach is that, on the exports side, a simultaneous equation estimation method is adopted. That is, we estimate an export supply (or export price) equation as well as an export demand equation. The importance of this method has been recognized by, for example, Goldstein and Khan (1978). These advantages of the approach enable us to capture a number of important features of Japan's foreign trade. In the analysis of exchange rate effects on the trade balance, the following aspects are emphasized. First, a depreciation of the exchange rate may be partially offset by a change in export price in the opposite direction. The magnitude of this offsetting effect is determined by the impacts on export price of competitors' price and prices of imported intermediate goods. Second, the impact of depreciation on the trade balance may also be weakened because depreciation raises the price of domestic manufactured goods and decreases people's incentive to switch from foreign to domestic manufactured goods. Third, as stated above, imports of fuels and raw materials are derived demands; therefore, price elasticities of these may not be very large in the short run. Among other variables affecting the trade balance, we focus on cyclical variables such as domestic and foreign incomes. There are direct effects of domestic income on the imports of intermediate goods and of foreign income on exports. In addition, we are especially interested in testing whether or not a domestic recession creates a pressure to increase exports. Such a possibility has been studied in the literature on the capacity pressure hypothesis. (See, for example, Dunlevy (1980).) In the following, we first explain the framework of the analysis and estimate equations for the components of the trade balance. The estimates are then used to assess quantitatively the importance of each of the mechanisms discussed above. It is shown that all these interrelationships between various components of the trade balance are important. We then proceed to present some simulation results that show the effects of exchange rate, cyclical variables, and input prices on the trade balance. They indicate that exchange rate changes exert a quick but not very large impact on the trade balance. An increase in the price of fuels leads to an immediate and significant worsening of the trade balance. Most important, cyclical variables have crucial effects on the trade balance. It is Received for publication April 5, 1982. Revision accepted for publication December 10, 1982. * Osaka Universitv. This paper is a substantially revised version of the first half of chapter 4 of the author's Ph.D. dissertation at M.I.T. The author would like to thank Stanley Fischer, anonymous referees of this Review, and the participants in seminars at the University of Tokyo, the Bank of Japan, Economic Planning Agency, and the Ministry of International Trade and Industry (Japan) for useful comments on earlier versions of the paper.