Impact of Exchange Rate on Exports and Imports

By
Aniqa Bashir
ROLL NO# 20845
Bushra Ashrif
ROLL NO# 20846

A RESEARCH PAPER
SUBMITTED TO THE DEPARTMENT OF
ECONOMICS IN PARTIAL FULFILLMENT OF
REQUIRMENT FOR THE DEGREE OF
ECONOMICS

Impact of Exchange Rate on Exports and Imports

Aniqa Bashir, Bushra Ashrif
Department of Economics,Government Postgraduate College Samanabad,Faisalabad

1. INTRODUCTION
Developments of world economies position financial systems as leaders in the world exchange
market.In open economies, foreign exchange rate policies are among the most important
macroeconomic indicators,because of the fact that they affect the business world’s investment
decisions.This is because the effect of foreign exchange rates on imports and exports also
directly affects the success of the policy, in terms of a reduction in the foreign trade deficit.
Today, the trends in the world economy as well as the movement of goods and services, labor,
technology and capital throughout the world, regardless of the geographical boundaries, affect
the economies of countries. Trade transactions involving more than one region normally require
the conversion of a currency to another currency.
The purpose of this research is to determine the impact of exchange rates on the imports and
exports of emerging countries. The intention of this research was to develop an empirical study
which will illustrate the nature of the relationship between imports-exports and exchange rates.
The movement in exchange rates will be assumed to be as a result of exchange rate policies.
Additionally, it is a chance for the researcher to apply theoretical knowledge to a practical
situation through critical and robust methodologies as described by Iqbal, Khalid & Rafiq (2011)
and Bhattarai (2011). In the next section, the literature review is summarized with the objective
of gaining adequate knowledge of the subject under research.
There are a number of factors other than exchange rate that affect exports and imports of a
country, which inter alia include:
i) Comparative / competitive advantage in production of product;
ii) Rich in endowments (labour, capital and natural resources)
iii) Technological advancement and research;
iii) Education and skills
iv) High factor productivity;
v) Compliance of quality and standards as per the provisions of
Agreements on SPS and TBT;
vi) Economies of scale;
vii) Political stability;
viii) Law and order, security situation;
ix) Intra-industry trade
x) Infrastructure and transportation costs
xi) Integration with the world economy through production chains;
xii) Trade to GDP ratio;
xiii) Cost of doing business
xiv) Market Access
xv) Foreign Direct Investment
xvi) High economic growth rate (GDP)
xvii) Interest rate
xviii) Inflation
xix) Saving rate
xx) Rate of Investment
xxi) Average applied tariff rate
The aim of this study was to empirically analyze the relationship between foreign exchange rates
and imports-exports for twenty two emerging countries over the period 1985-2012. The list of
emerging countries used in the model, reproduced in the Appendix I.
In the literature, there have been several studies indicating the relation between real exchange
rate (RER) and foreign trade. However, this study differentiatesfrom previous studies in two
aspects.
First, although in previous studies generally real foreign exchange rate has been used as a
dependent variable, in this study the real effective foreign exchange rate was used as an indicator
that considers inflation differences, as well. Second, although most of studies in the literature
investigate the effect of foreign exchange rates on the foreign trade balance, in this study the
effect of foreign exchange rates on imports and exports were analyzed separately.
In the second part of the study similar studies in the literature and different opinions are
mentioned. and In the third part,information about the empirical methodology and data are given
and the empirical results are evaluated. Finally, the results and evaluations are mentioned.

2. LITERATURE REVIEW
Hooper and Kohlhagen (1978) analyzed systematically the effects of exchange rate uncertainty
on the trade. They investigated bilateral and multilateral trade among developed countries during
1965 to 1975. They measured exchange rate risk by standard error of nominal exchange rate
fluctuations. They could not establish any significant impact of exchange rate volatility on the
volume of trade. They measured the exchange rate risk volatility as the standard error of nominal
exchange rate function.
Akhter and Hilton (1984) examined the bilateral trade between West Germany and US. They
determined that the exchange rate volatility has a significant negative impact on the exports and
imports of two countries. However, the volatility of exchange rate has been measured by the
standard deviation of effective exchange rates. The criticism on this study is that the researcher
used the many countries and considered them on unit so he never get a good result because he
was not specify the country.
Hossein and Rahman (1995) has hypothesized that Bangladesh export supply is a function of
relative prices of its exports and the capacity output of the tradable sector. They have estimated
the demand and supply models of exports with annual data and found that Bangladeshis export is
highly sensitive to the income growth of its trading partners and estimated that a 10% rise in a
foreign income would raise the demand for Bangladeshi exports by 23%.In this article researcher
shown just one side of the exchange rate that the increase in the foreign income the export of
Bangladesh increased but no focus that if the income of the foreign people decrease then what
will happen so this study not give the exact results.
Arize et al. (2003) examined that does exchange rate volatility depress the export flows in case
of ten developing countries over the quarterly period 1973 to 1998. Exports used as dependent
variable while relative prices, world demand conditions and exchange rate volatility use as
independent variable. Study use Johansen’s multivariate procedure and Error correction
mechanism (ECM) techniques to check the relationship of the variables under consideration.
Results of the model shows as increase in the exchange rate volatility exert a significant negative
effect upon export demand in both the short-run and long-run.
Mustafa and Nishat (2004) explore the relationship of volatility of exchange rate and export
growth of Pakistan using quarterly data from 1991:3 to 2004:2. Export growth is used as
dependent variable while exchange rate volatility use as independent variable. The study use
Error co-integration technique to check the relationship among the variables in the model.
Results of the study shows that there is negative relationship in case of major trade partner UK
and USA, while in case of Pakistan and India this relationship is observed only long run not in
short run.
Korhonen and juurikkala (2008) asses the determinants of equilibrium real exchange rates in a
sample of oil dependent countries by using the annual time series data from 1975 to 2005. Study
use ARDL and ECM techniques to check the short run and long run relationships among the
variables. Result of the study shows price of oil has a clear statistically significant effect on real
exchange rates.
Obstfeld (2009) posits that one of the puzzles in global macroeconomics is the small impact that
large and significant exchange rate movements have on exports andimports. They conducted a
study on international finance aspects and growth in emerging countries and found that there is a
very small but significant impact of large exchange rate policy movement. Exchange rate
policies changes can be identified by the changes in exchange rates of a country. Consequently,
there is a significant disconnect between international products (imports and exports) and
exchange rates.
Oleg& Roberto (2011) have defined it as completeness where a one-for-one response exists. In
other words, when a 1% fluctuation in the exchange rate results in fluctuation of 1% change in
the import price, then there is complete exchange rate pass through. Existence of this relationship
indicates that there is a co-integration relationship between these two variables. Roberto suggest
that exchange rate movements due to policies can be passed through to goods and services trade
prices.Alternatively, the price can be absorbed in producers’ profit mark ups and margins.
Aftab and Abbas (2012) concluded that exchange rate instability has significant negative
relationship with sectoral export of Pakistan except waxes and animal oils, aircraft, transport
equipment and arms however the signs of coefficient are negative relative price also show sign
negative relationship for all the sectors except animal and vegetable, textile and textile articles
were negative sign. Negative sign shows that decrease in demand for exports is due to an
increase in relative price.
Aman et al. (2013) examined the relationship between exchange rate and economic growth in
case of Pakistan by using time series date from 1976 to 2010. GDP is dependent variable while
exports, imports, domestic savings, investment and FDI use as independent variable. Study use
Simultaneous equation model (2SLS and 3SLS techniques). Result of this study show that
exchange rate has positive associated with economic growth through the channel of export
promotion incentives, enlarging the volume of investment, enhancing FDI inflow and promoting
import substitute industry.
Haseeb and Rubaniy (2014) explore the relationship among exchange rate instability and
sectoral exports in case of Pakistan. Sectorial export is dependent variable and exchange rate is
independent variable and GDP use as control variable. Study use ARDL technique to check the
relationship among the variables. Results of the study shows negative relationship between
exchange rate volatility and export of food processing machinery, grapes, meat and petroleum
products but with iron and steel bars this is adjusted in long run.

3. OBJECTIVES OF STUDY
The objectives of the study are
• To examine the impact of Exchanged Rate on Exports and Imports
• To give policy recommendation
4. RESEARCH METHODOLOGY
This study use a log linear regression model to determine the effects of exchange rate
fluctuations on exports and imports. The error correlation model furthermore will be used in
determining the speed and the direction of the impact adjustment. The functions’ of export and
import associated with exchange rates and independent variables are;
M= g(EXV,RRT, Ydomesttic,Pm, TTm).......1
X= f(EXV,RRT,Yforeign, Px,TTx).............2
Where represents real aggregate imports and exports respectively;
EXV is real exchange rate volatility,
Ydomesttic,Yforeign Represent domestic and foreign national income
Pm,Px Represent the relative price of imports and export respectively
TTm,TTx Represent terms of trade for import and export function respectively.
Transforming the above models to log-linear import and export function results in;
4.1. Import function
InMt = B0 + B2InEXVt + B3 Log Ydomestic + B4InRRTt + B5InTTt + ut........3
InMt , is the import, LogEXV is real exchange rate volatility,
InRRT is the real exchange rate
InYdomestic Represent domestic national income
InTTt Represent terms of trade for import function
B0...B5 are the coefficient and u is the disturbance term.
4.2.Export function
Xt = a0 + a2InEXVt + a3 In Ydomestic + a4InRRTt + a5InTTt + Et........4
InXt , is the import, logEXV is real exchange rate volatility,
InRRT is the real Exchange rate
In Ydomestic Represent domestic national income
InTTt Represent terms of trade for import function
a0.....a5 are the coefficient and E is the disturbance term.

5. RESULTS AND DISCUSSION

Real exchange rate volatility
The volatility of exchange rates is indirectly observable several methods has been used to
explore it. In determining volatility this study followed Sauer and Bohara 2001 using conditional
variance and exchange rate of the first order ARCH model.
In(RRt)= a0 + a1 In(RRt-1) + ut.........4
Estimating equation (4) gave the following results (standard errors are in parenthesis).
Volatility, ot =0.3345 + 0.9518 u2t-1
The results are interpreted as current projections of real exchange rate changes which are
measures of the long term average and weighted average of the term ARCH. The predicted value
of ot measures the volatility of the Kenyan exchange rate against US dollar. After determining
that all variables under the study were stationary at first difference it is important to determine
the long term relationship between dependent and the independent variables. The results indicate
that there is Cointegration and there are at least 2 integral equations. This means that
dependencies are closely related to independent variables to achieve long term equilibrium.

The lnEXV logY domestic lnRRT and lnTT coefficients were significant at a significance level
of 5%. The error correction mechanism ECM has a coefficient of 0.214 which means that the
difference between the balance and the system shall be unstable. The econometric results shows
that output coefficients in the local logY lnEXV and lnTT are positive but the coefficients of the
real exchange rate is negative. It has been observed that the increase in domestic income has had
a positive impact on import demand but the depreciation of the real exchange rate has had a
negative impact on the long term dynamics of the import mode.
In the results the coefficients of lnEXV, logY lnRRT were significant at the 5% level while the
lnTT coefficients were not significant at the 5% level. The output coefficient of the error
correction mechanism MCE is 0.068 which means there is a negative and significant long term
relationship. The estimation equation indicate that the coefficient of Y_foreign and TT are
positive the real exchange rate fluctuation coefficient the real exchange rate is negative and
statistically significant. This means that the increase in actual foreign income and the
improvement in terms of the trade TT have had a positive impact on export demand while the
volatility of real exchange rates and real exchange rates have had a negative effect on exports.
6. CONCLUSIONS
Based on empirical analysis the results show that trade maybe be improved if policies related to
macroeconomic policies aimed at maintaining a stable real exchange rate are implemented. Thus
policy makers should develop coherent policies to achieve a stable exchange rate regime to
achieve and maintain the stability of real exchange rate, thereby promoting the overall economic
growth of trade and the economy country.

REFERENCES
• Aftab, M., Abbas, Z. and Kayani, N.F. (2012)
Impact of Exchange Rate Volatility on Sectoral Exports of Pakistan: An ARDL Investigation.
Journal of Chinese Economic and Foreign Trade Studies, 5(3), 215-231.
Arize, A. C., Malindretos, J., and Kasibhatla, K. M. (2003). Does Exchange-Rate Volatility
Depress Export. IAER,9(1), 30-40.
• Akhtar, M., and Hilton, R. S. (1984)
Effects of Exchange Rate Uncertainty on German and U.S. Trade. Federal Reserve Bank of New
York Quarterly Review, 9, 7-16
• Bhattarai, K. (2011)
Panel Data Models: Econometric Analysis. Hull University
• Hooper, P. and Kohlhagen, S. W. (1978)
The Effect of Exchange Rate Uncertainty on the Prices and Volume of International Trade.
Journal of International Economics, 8(4), 483-511.
• Haseeb, M., and Ghulam R. (2014)
Exchange Rate Instability and Sectoral Exports: Evidence from Pakistan. A Research Journal of
Commerce, Economics and Social Sciences, 8(1), 26-40.
• Iqbal, A, Khalid, N. & Rafiq, S. (2011)
Dynamic Interrelationship among the Stock Markets of India, Pakistan and United States.
International Journal of Human and Social Sciences. 6 (1) pp. 31-37
• Mustafa, K. and Nishat, M. N. (2004)
Volatility of exchange rate and export growth in Pakistan: The structure and interdependence in
regional markets. The Pakistan Development Review, 43(4), 813-828.
• Obstfeld, M. (2009)
Lenders of Last Resort in a Globalized World. Keynote address, 2009 International Conference,
Institute for Monetary and Economic Studies, Bank of Japan.
• World Bank (2013)
Country indicator data base. Washington D. C: World
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