Abstract:
This article is an attempt to examine the short and long-run
relationship between the trade balance, income, money supply, and real
exchange rate in the case of Pakistan’s economy. Income and money
variables are included in the model in order to examine the monetary and
absorption approaches to the balance of payments, while the real exchange
rate is used to evaluate the conventional approach of elasticities (Marshall
Lerner condition). The bounds testing approach to cointegration and error
correction models, developed within an autoregressive distributed lag
(ARDL) framework is applied to annual data for the period 1970 to 2005
in order to investigate whether a long-run equilibrium relationship exists
between the trade balance and its determinants. Additionally, variance
decompositions (VDCs) and impulse response functions (IRFs) are used to
draw further inferences. The result of the bounds test indicates that there
is a stable long-run relationship between the trade balance and income,
money supply, and exchange rate variables. The estimated results show that
exchange rate depreciation is positively related to the trade balance in the
long and short run, consistent with the Marshall Lerner condition. The
results provide strong evidence that money supply and income play a strong
role in determining the behavior of the trade balance. The exchange rate
regime can help improve the trade balance but will have a weaker
influence than growth and monetary policy.
