«The Effects of Macroeconomics Shocks on Exchange Rate and Trade Balances in Korea* Batbayar Buyangerel Won Joong Kim This study ...»
Korea and the World Economy, Vol. 14, No.1 (April 2013) 91-119
The Effects of Macroeconomics Shocks on Exchange Rate
and Trade Balances in Korea*
Batbayar Buyangerel Won Joong Kim
This study analyzes the effects of various macroeconomic shocks
on exchange rate and trade balance in South Korea using a structural
vector error correction (SVEC) model. Conventional theories such as
exchange rate overshooting and J-curve effects are re-examined by
allowing for the endogeneity among relevant macroeconomic variables. The study identifies the structural relationship among different macroeconomic variables by imposing the short-run and the longrun identifying restrictions based on the various macroeconomic theories.
The impulse responses analysis results conform to our expectations.
An interest rate shock (or contractionary monetary policy shock) causes exchange rate (KRW/foreign) to fall (or Korean Won to appreciate) and trade balance to worsen. Money supply shocks lead to a depreciation of Korean Won and an improvement of trade balance.
Price level shocks cause Korean Won to depreciate and trade balance to improve. The output shocks lead to an appreciation of Korean Won, worsening the trade balance. In addition, the exchange rate depreciation shock of Korean Won leads to an improvement in trade balance. The results show that exchange rate overshooting is found only from its own exchange rate shock. We find no evidence of Jcurve effect. Instead, we find that the exchange rate shock causes an instant and small improvement in the trade balance and the magnitude of improvement in trade balance gets bigger in the long run.
JEL Classification: E52, F31, F4 Keywords: exchange rate overshooting, trade balance, J-curve effects, structural vector error-correction (SVEC) model, impulse response, variance decomposition * Received August 30, 2012. Revised October 3, 2012. Accepted March 5, 2013.
Graduate student, Department of Economics, Kangwon National University, Korea, E-mail:
email@example.com Author for correspondence, Associate Professor, Department of Economics, Konkuk University, Korea, E-mail: firstname.lastname@example.org Batbayar Buyangerel Won Joong Kim
1. INTRODUCTION In 1973, a largely flexible, market-based pricing mechanism for currencies was introduced due to the breakdown of exchange rate controls imposed by the Bretton-Woods System. Since then, many researchers have investigated on topics related to the effects of macroeconomics shocks on exchange rate and trade balances. They have come up with different results, given the different coverage of countries, periods and different econometric methods.
A classical explanation of exchange rate overshooting comes from price rigidity. According to the model, when a change in monetary policy occurs, the market will adjust to a new equilibrium between prices and quantities.
Initially, because of the “stickiness” of prices of goods, the new short run equilibrium level will first be achieved through shifts in financial market prices. Then, gradually, as prices of goods “unstick” and shift to the new equilibrium, the foreign exchange market continuously re-prices, approaching its new long-term equilibrium level. Only after this process has run its course will a new long-run equilibrium be attained in the domestic money market, the currency exchange market, and the goods market. As a result, the foreign exchange market will initially overreact to a monetary change, achieving new short run equilibrium. Over time, goods prices will eventually respond, allowing the foreign exchange market to dissipate its overreaction, and the economy to reach the new long run equilibrium in all markets. So the main focus of the exchange rate overshooting was on the effect of monetary policy on exchange rate.
J-curve effects state that a country’s current account worsens immediately after real currency depreciation of domestic currency and improves with some lags. The theoretical basis of the J-curve effect comes in part from Alfred Marshall and Abba Lerner, whose “Marshall-Lerner Condition” states that if initially the balance of trade is zero, and if supply elasticities are infinite, then the absolute values of export and import demand elasticities have to be at least large enough to add up to unity to have an exchange rate devaluation bring about the surplus in balance of payments. This theory can The Effects of Macroeconomics Shocks on Exchange Rate and Trade Balances in Korea 93 be proven by looking at the changes in elasticity over time. In the short run, elasticities are small, making the Marshall-Lerner Condition less likely to be satisfied. However, as time goes by, elasticities become larger, ultimately crossing the threshold point described by Marshall and Lerner, thus creating the condition for an improvement in the balance of payment.
After careful examinations of the births of exchange rate overshooting and J-curve effects, we can infer what researchers have done for these issues.
Regarding the exchange rate overshooting, the main focus was how monetary policy affects the exchange rate both in the short run and in the long run.
However, the findings on exchange overshooting differ by estimation strategy (reduced-form approach such as OLS or structural-form approach), by country and by estimation periods. Regarding the J-curve effects, researchers’ focus was either on measuring the effects of exchange rates on the trade balances, the elasticities of import and export with respect to exchange rates. Again, the findings on J-curve effects differ by estimation strategy, by country and by estimation periods.
Exchange rate overshooting and J-curve effects may be found from different macroeconomic activities in addition to variables specified in each theory. Therefore, the paper is to investigate the effects of not only the monetary policy shock but also other macroeconomic shocks, such as exchange rate shock, price level shock, output shock, on exchange rate and trade balance. To identify the structural macroeconomic shocks, the paper employs the structural vector error correction (hereafter, SVEC) model with non-recursive short-run and long-run identifying restrictions. The estimation results from conventional structural VAR (hereafter SVAR) may be biased if there is any cointegration relationship among relevant macroeconomic variables. Also, the main advantage of SVEC over SVAR is that SVEC greatly reduces the number of identifying restrictions by imposing cointegrating relationship in the long-run matrix.
The paper is organized as follows. In section 2, we review the literature on exchange rate overshooting and the J-curve effects and surveys the studies that analyze either exchange rate overshooting or J-curve effects in Korea. In Batbayar Buyangerel Won Joong Kim section 3, we introduce the SVEC we employed to analyze how different macroeconomic shocks affect the exchange rate and trade balance. The empirical analysis and the results are discussed in sections 4 and 5. Finally, section 6 concludes the paper.
There are number of theoretical hypotheses on how macroeconomic shocks effect on exchange rate, trade balance. The paper deals with the two general hypotheses: (i) exchange rate overshooting and (ii) J-curve effects.
2.1. Exchange Rate Overshooting Hypothesis and J-Curve Effects Exchange rate overshooting hypothesis was first developed and exemplified by Rudi Dornbusch (1976) with sticky price model. It was shown that an increase in the (exogenous) money supplies would cause exchange rate, first, to depreciate beyond its long run equilibrium value, and then appreciate back to the steady state. Apart from this, some other congruent results were found by Frankel (1979) with two country model.
The prevalent works from the body of theory related to Dornbusch’s hypothesis and exchange rate dynamics include Frenkel and Rodriguez (1982), Mussa (1982) and Eaton and Turnovsky (1983), Sims (1992), Eichenbaum and Evans (1995), Alvarez et al. (2001), Chari et al. (1996), Gourinchas and Tornell (1996), McGrattan (1998), Kollmann (1998).
When it was confronted with the data, however, few empirical studies that analyzed the effects of monetary policy supported Dornbusch’s exchange rate overshooting hypothesis (see, for example, Kim and Roubini (2000) for G7 countries, Peersman and Smets (2003) and Favero and Marcellino (2001) for the aggregate Euro area, Mojon and Peersman (2003) for individual Euro area countries and Lindé (2003) for Sweden). Instead, they found that following a contractionary monetary policy shock, the domestic currencies The Effects of Macroeconomics Shocks on Exchange Rate and Trade Balances in Korea 95 generally and gradually appreciate. Regarding the U.S., Jang and Ogaki (2004) found the evidence of the exchange rate overshooting to a contractionary monetary policy shock. On the other hand, Eichenbaum and Evans (1995) found no exchange rate overshooting to a contractionary monetary policy shock.
The J-curve hypothesis suggests that if domestic currency depreciates, it causes exports price to fall (in terms of the buyer’s currency). Exports are, therefore, expected to rise. Likewise, imports are expected to fall as the rest of the world’s goods and services become more expensive for domestic residents. Thus, a country attains a trade surplus in the long-run. However, the J-curve hypothesis articulated the aforementioned process is not an immediate phenomenon. It emphasized that the trade balance may worsen when the quantities of export and imports did not adjust immediately to the depreciation of domestic currency. Trade balance deteriorates in the short run because of the depreciation of domestic currency. However, as time progresses, the quantity of imports goes down and exports goes up. It implies that the trade balance improves due to depreciation of the domestic currency in the long-run. In sum, an expansionary monetary policy will have J-shaped effects on trade balance: it initially causes a trade deficit and then leads to a trade surplus. 1) Some research claims that the phenomenon of J-curve does not apply to every country. Rose and Yellen (1989) found that the J-curve effects do not apply to G-7 countries. Rose (1990) also found no J-curve effects for 30 developing countries over 18 years. Koray and McMillin (1999), for example, investigated the response of the exchange rate and the trade balance to monetary policy shocks for the U.S. economy during the period 1973:01using SVAR model. Their results showed that contractionary monetary policy shocks lead to transitory appreciations of the real and the nominal exchange rate. Causes of this shock to monetary policy led to a 1) Kim (2007a, 2007b) also measured the effect of exchange rate on export. However, his focus was only on the exchange rate pass-through and had limitation in analyzing J-curve effect.
Batbayar Buyangerel Won Joong Kim short-lived improvement in the trade balance which was then followed by deterioration in the trade balance, giving support to the J-curve hypothesis.
Hakcer and Hatemi-J (2003) also found the J-curve effects for five small northern European economies. Kim (2001), however, found that, for France, Italy and the United Kingdom, the effects of monetary policy shocks on trade balance are consistent with expenditure-switching effect, but there is a little evidence of J-curve effect. Jannsen and Klein (2011) used a structural VAR model of the euro area and found that a monetary policy shock in the euro area leads to a largely similar change in the interest rate and GDP in other western European countries. They also found that the effects of monetary policy shock on exchange rates are limited and trade balances are usually unaffected.
2.2. The Case of Korea
Kwack (1988) showed that a change in the external currency value of a country has direct effects on the trade via changes in relative prices and indirect effects via induced changes in income and monetary conditions. He found that an exchange rate appreciation is shown to worsen the trade balance, lower price levels and overall economic growth.
For the periods of 1973-1980, Bahmani-Oskooee (1985) found an evidence of an inverse J-curve effect in Korea. Bahmani-Oskooee and Malixi (1992) also found evidence of J-curve effect in Korea. Lal and Lowinger (2002) also confirmed the existence of J-curve effects in Korea.
Hsing and Savvides (1996), on the other hands, found no J-curve phenomenon in Korea. Hsing (2003), unlike what the traditional J-curve theory predicts, found a rise in initial trade ratio (export/import) of Taiwan and Korea was observed during the currency depreciation period. Hsing emphasized that “the finding is consistent with the hypothesis for small open economics (with original trade surplus), which assumes both export and import are dominated in foreign currency”. Bahmani-Oskooee and Ratha (2004) showed that long-run effects of depreciation of Korean Won are The Effects of Macroeconomics Shocks on Exchange Rate and Trade Balances in Korea 97 advantageous in case of Korea-US trade.
Recently, Kim (2011) examined the sources of fluctuations in real exchange rate and trade balance in Korea using key macroeconomic variables such as cross-country output differential, real exchange rate and trade balance using structural VAR with long-run and recursive identifying restrictions. He found that all three shocks (supply shocks identified from output differential equation, demand shocks from real exchange rate equation and nominal shock identified from trade balance equation) have nonnegligible impacts in explaining fluctuations in real exchange rate. He found that real exchange rate depreciation (demand) shock of Korean Won led to a deterioration of trade balance and that trade balance improvement (nominal) shock of Korea lead to a depreciation of Korean Won. Regarding the worsening of trade balance in response to a real exchange rate depreciation shock, which is contradictory to theoretical expectations as implied by the expenditure switching effect, Kim (2011) argued that it is possible if the demand shock is interpreted either as home-country government spending shock or taste shocks toward domestic goods. Those shocks will cause the real exchange appreciation of Korean Won and the increase the relative demands for domestic goods hence the improvement of trade balance.