How Does a Depreciation in the Exchange Rate Affect Trade Over Time?

Abstract: The purpose of this thesis is to examine how a depreciation in the exchange rate affects the trade balance in an economy over time. The outcomes of a depreciation are possible to analyze through the J-curve phenomenon that shows the relation between the exchange rate and the trade balance both in the short-run and the long-run. The data used in this thesis cover 39 countries and their quarterly changes in exchange rate between 1982 and 2005. The largest depreciation for each country during these years was detected and is the base for this research. In this thesis, focus is on the trade ratio rather than the trade balance for empirical purposes. The relation between the largest depreciations and its effect on the trade ratio are examined in two sets of regressions. The results show no evidence of a J-curve in neither one of the sets of regressions, even though the trade ratio is positively affected by the depreciation. When testing only for significantly large depreciations in the exchange rate the affect on the trade ratio is stronger, all else equal. According to the findings in this thesis, a depreciation in the real effective exchange rate causes the trade ratio to increase immediately and then decrease over time. The conclusion is that the findings are not in line with the J-curve phenomenon tested for; however, they support standard trade theory with the Marshall-Lerner condition being met i.e. a depreciation in the exchange rate will affect the trade balance positively.