Chapter 6: The Effect of Exchange Rate Adjustment on the Trade Balance
THE STYLIZED FACTS The stylized facts described in this chapter pertain to movements in the exchange rate, trade balance and trade volumes. To start with, a large number of historical episodes show that the trade balance does not improve following domestic currency devaluation or depreciation. One such episode that is frequently referred to is the significant deterioration of the US trade balance in 1972 despite the 1971 devaluation of the dollar following the collapse of the Bretton Woods system. In this section we examine the facts and figures about how the exchange rate is related to the trade balance. The analysis is based on data (covering several countries) extracted from the International Financial Statistics of the International Monetary Fund. The Bilateral Figures Consider first Figure 6.1, which shows the US trade deficit with China (dotted line) and the yuan/dollar nominal exchange rate since June 1993. A trend is superimposed on the trade balance to emphasize the observation of a long-term tendency for the deficit to widen, irrespective of the exchange rate. The most striking observation is that during the period up to July 2005, when the exchange rate was fixed, the deficit widened continuously while exhibiting some sort of a seasonal pattern (the almost regular ups and downs). The widening of the US trade deficit with China while the exchange rate was fixed is typically explained in terms of the undervaluation of the yuan, in the sense that the exchange rate was at such a high level that it made...
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