Academic journal article Journal of Economics and Finance

The J-Curve: Evidence from Commodity Trade between Canada and the U.S

Academic journal article Journal of Economics and Finance

The J-Curve: Evidence from Commodity Trade between Canada and the U.S

Article excerpt

Abstract

Several studies in the literature have tried to assess the impact of real depreciation of the Canadian dollar on the Canadian trade balance. They have either relied on the trade data between Canada and the rest of the world or between Canada and her major trading partners. In this paper we consider the trade between Canada and her major trading partner, the U.S. However, unlike previous research, we disaggregate the trade data between the two countries by commodity. We use export and import data over the period 1962-2004 from 152 commodities and the bounds testing approach to cointegration and error-correction modeling and show that real depreciation of the Canadian dollar has short-run effects on the trade balance of two-thirds of the industries. However, only in 50% of the industries, the short-run effects translate into the long-run favorable effects.

Keywords J-Curve * Bounds testing approach * Industry data * Canada * U.S.

JEL Classification F31

1 Introduction

A country devalues its currency under a fixed exchange rate system or allows its currency to depreciate under a flexible exchange rate system with the intention to increase the country's competitiveness resulting in an increase in its net exports. Given that an individual country is small relative to the rest of the world one condition that is required for a successful devaluation is the fulfillment of the Marshall-Lerner condition, i.e., sum of import and export demand elasticities exceeding unity. The Marshall-Lerner condition, however, is considered a long-run condition. The J-Curve concept which was introduced in 1973 by Magee (1973), asserts that it is possible for devaluation or depreciation to worsen the trade balance in the short-run before showing improvement. Thus, while earlier studies concentrated on testing the Marshall-Lemer condition, more recent studies have tried to distinguish the short-run effects of devaluation from its long-run effects and assess the validity of the J-Curve hypothesis. Bahmani-Oskooee and Ratha (2004a) provide a comprehensive review of the literature.

The review by Bahmani-Oskooee and Ratha (2004a) is general and does not address any country's experience with the J-Curve. Since this paper is concerned with the Canadian experience, a brief review of the literature related to Canada is in order so that we can distinguish and highlight the contribution of this paper relative to other papers. We classify the articles into two groups. The first group includes those studies that have used aggregate trade data between Canada and rest of the world. The second group includes those studies that have relied upon bilateral trade data between Canada and her other major trading partners, especially the U. S.

In a reduced-form model which was designed to assess the direct impact of exchange rate changes on the trade balance, Rose (1991) estimated a VAR model in which the trade balance was related to the current and lagged values of the exchange rate in addition to current and lagged values of domestic and foreign incomes. The model was estimated for five large countries including Canada and it was concluded that "the exchange rate is not a significant determinant of the trade balance".1 This was the result for Canada and most other countries in the sample. The same was concluded by two other studies when they estimated the Marshall-Lerner condition. Canada was one of 30 countries for which Bahmani-Oskooee and Niromand (1998) employed Johansen's cointegration approach and estimated relative price and income elasticities using aggregate trade data. For Canada, the sum of the price elasticity of Canadian import demand and the price elasticity of rest of the world demand for Canadian exports did not exceed unity, implying that real depreciation of Canadian dollar cannot improve the Canadian trade balance in the long run. Similar results were confirmed by Caporale and Chui (1999) when they used, again, aggregate trade data, but estimated price elasticities by the ARDL and DOLS methods. …

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