Exchange rate and trade balance in Zambia: An empirical investigation of the J-Curve effect

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Kamwi, Mulele
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Trade balance is one of the main factors affecting the balance of payments position. This study examined the relationship between exchange rate and trade balance in Zambia, both in the short run and long run using quarterly data from 1998:1 to 2009:4. The study investigated how trade balance responds to exchange rate changes over time and if the J-curve exists for Zambia. The elasticity approach to the balance of payments was the theoretical framework applied in this study. The elasticity approach contends that there is a long term relationship between exchange rate and trade balance, though disequilibrium may exist in the short run.A number of studies done in the past have shown that the relationship between exchange rate and trade balance varies across countries. Predictions about effects of exchange rate changes on the balance of trade may be affected by a number of factors. Apart from behavior of economic agents, macroeconomic and structural conditions that exist in a country may affect the responsiveness of imports and exports to exchange rate changes. Cointegration, Vector Error Correction modeling and Impulse Response Functions are the time series econometric methods applied in this study. The empirical results have shown that there is a long term equilibrium relationship between exchange rate and trade balance. Depreciation of the exchange rate is effective in improving the Zambian trade balance in the long run. However, in the short run the trade balance initially deteriorates but eventually improves over the long run. Therefore, the response of trade balance to exchange rate appears to follow the J-Curve. The Marshal-Lerner condition for depreciation to improve trade balance is met in the long run, but not in the short run.The Granger causality results have shown that causality runs from exchange rate to trade balance and not the other way round. Therefore, exchange rate may be used to influence and provide information about trade balance developments in Zambia. Policies that ensure stability and competitiveness of exchange rate should be promoted as one of the ways of strengthening the external balance position.
Exhange rates , International trade , Trade balance