Exchange rates and trade balance adjustment: the case of Taiwan

Abstract

This dissertation explores the effect of exchange rate changes on the trade balance of Taiwan. It has two objectives. The first is to present a basic conceptual framework of trade adjustment to model Taiwan's trade flows. Development of the model draws on literature that examines the sensitivity of trade flows to changes in exchange rates. The second objective is to evaluate empirically the responsiveness to exchange rate fluctuations of Taiwan's trade imbalances with the United States and Japan. A partial equilibrium empirical trade adjustment model that explicitly regarded the supply effect of changes in import prices on the export market was presented. This was done to reflect the fact that Taiwan has few natural resources and relics to a large extent on imported raw materials, energy, and other intermediate inputs for its production. The challenge is to estimate both the structural and reduced-form specifications by applying the methods of modem time-series econometrics to analyze the long-run trade balance adjustment and its relation to short-run dynamics. The estimates generally support a role for exchange rate policy as a tool to reduce Taiwan's trade imbalance. Taiwan's exports and imports appear to be sensitive to changes in exchange rates and Taiwan's currency depreciation is found to have a positive effect on the trade balance. These findings are consistent with the traditional findings of international trade economists which have been challenged by recent studies. However, in the short run, the J-curve effect may exist, suggesting that Taiwan's exports and imports are insensitive to changes in exchange rates and a depreciation in Taiwan's currency is likely to have an initial perverse effect on the trade balance in the short run. The responsiveness of Taiwan and Japan trade to exchange rate changes appears to be smaller than that of Taiwan and the United States trade. The supply effect of import prices on Taiwan's exports docs not dominate the effect of an exchange rate change on the trade balance in the long run, but appears to have some impact in the short run.