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Table of Contents
1.

2.

3.

BACKGROUND................................................................................................. 2
1.1.

Introduction............................................................................................... 2

1.2.

Statement of Problem............................................................................... 3

1.3.

Objectives of the Study.............................................................................3

1.4.

Organization of the Study.........................................................................4

LITERATURES REVIEW...................................................................................... 5
2.1.

Introduction............................................................................................... 5

2.2.

Theoretical Literature................................................................................5

2.3.

Empirical Literature................................................................................... 6

METHODOLOGY............................................................................................... 9
3.1.

Introduction............................................................................................... 9

3.2.

Data.......................................................................................................... 9

3.3.

The Model................................................................................................. 9

3.4.

Methods of Estimation............................................................................. 12

4.

FINDINGS AND DISCUSSION..........................................................................15

5.

CONCLUSION................................................................................................. 15

REFERENCES........................................................................................................ 16

1. BACKGROUND
1.1.Introduction
There is this tacit understanding in devaluation of a currency where it is
used as a mechanism to improve balance of trade. Exports prices become
cheaper while imports prices increase as the value of local currency drops.
Consequently, the trade balance improves. However, the effect of exchange rate
on trade balance might vary from a country to a country due to different level of
economic development. One of the notable effects is the Marshall-Lerner
condition. This condition states that when the sum up value of import and export
demand elasticity is equal to, or greater than 1, the devaluation in currency
exchange rate will cause trade balance to increase (Chen & He, 2011).
Malaysia's ringgit had the biggest two-day decline since the 1997-98 Asian
financial crisis recently as reported by Y-Sing and Han (2014). The ringgit fall 2.4
percent to 3.4300 per US Dollar on Monday December, 1 st at closing, from 3.3465
per US Dollar on Thursday November, 27th at closing. The depreciation in ringgit
is due to a ripple effect of declining in world price of oil. The declining in price of

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Brent crude oil of 38 percent from its June high thus reducing the countrys
revenue as oil is one of Malaysia's main exports. This situation has made it
harder for government to achieve its fiscal deficit target.
Despite shrinking in ringgit, Deputy Finance Minister Datuk Ahmad Maslan
said to Bernama that it will not harmfully affect Malaysia's economy. He
mentioned that the ringgit would remain stable in the long term and Malaysia's
economy would grow within government's expectation in 2015. In addition, this
situation is said to be beneficial for tourism and exports as well as certain
sectors. On the other hand, Minister of International Trade and Industry, Datuk
Seri Mustapa Mohamed said to Bernama that currently a joint study has been
conducted between Bank Negara Malaysia, Ministry of Finance (MOF) and the
Economic Planning Unit (EPU) of the Prime Minister's Department to analyse the
advantages and disadvantages of depreciation in ringgit towards the economy.
He also mentioned that there is no possibility to peg the ringgit against US dollar
as the move has its own benefits and drawbacks.
1.2.Statement of Problem
Devaluation in currency would increase the price of imported goods and at
the same time decrease the price of domestic goods. Hence, local manufacturing
sector can be expanded. Besides that, a country's export sector also could be
developed as its exports to foreign countries will be much cheaper. Due to the
expansion in export sector, company profit, salaries, bonuses, manpower, and
tax for the government also will increase.
It must be noted that although the currency's devaluation might have
positive influences towards economy, the amount of export and import may not
react at initial period of devaluation. Worse thing to happen is that trade balance
may be falling first due to decrease in value of export and increase in value of
import. However, these numbers might improve after some time. This whole
scenario is known as J-curve.
Due to the above situation, it is important for government and related
regulatory bodies to come hand in hand investigating the relationship between
real exchange rate and trade balance and check whether the depreciating
currency is good or bad and if it has a positive effect towards the economy. It is
also significant for researchers to determine whether J-Curve effect exists
following the depreciation in currency.
There have been numerous studies focusing on the impacts of exchange
rate volatility on balance of trade; however, none could be found comparing
these effects between Malaysia, Indonesia, and Thailand. Main focus of this
paper would be Malaysia while Indonesia and Thailand will be used to compare
their results with Malaysia. Indonesia and Thailand have been chosen due to the
fact that they are Malaysias neighbouring countries and the two countries share
similar economic environment.

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1.3.Objectives of the Study

The main aim of this paper is to investigate the relationship between the
real exchange rate and trade balance in Malaysia, Indonesia, and Thailand from
year 1990 until 2014. In addition, this study also targets to determine whether
Marshall-Lerner condition and J-Curve exist in these three countries during the
study period.
1.4.Organization of the Study
This paper is structured into several sections. After introduction, section 2
discuss further on theoretical and empirical literature review. Next, section 3 will
have discussion on model and methods of estimation being used in this study.
After that, section 4 will be the findings and discussion. Finally, section 5 will be
the conclusion from this study.

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2. LITERATURES REVIEW
2.1.Introduction
Despite so many studies done on finding the relationship between real
exchange rate and balance of trade, little studies could be found on comparing
the intended results between the three sample countries, i.e. Malaysia,
Indonesia, and Thailand. The next subsections will discuss on theoretical
literature and empirical literature related to the topic of this research.
2.2.Theoretical Literature
Setting all other variables fixed, the trade theory declares that the
exchange rate can affect a countrys imports and exports. A fluctuation in the
exchange rate affects both the value and volume of trade. If the real exchange
rate increases for the home country i.e. if there is a real depreciation, the
households in the home country can obtain less foreign goods and services in
exchange for a unit of domestic goods and services. Therefore, less foreign
goods are obtained because of their higher prices.
Lerner (1944) mentioned that lower prices in the domestic country will
generally increase foreign demand for domestic countrys good, but only if the
foreign elasticity of demand is elastic. On the other hand, if the domestic
demand for foreign goods is elastic, the price change in the domestic market will
change the domestic consumers behaviour. The consumers will then switch to
consume domestic goods rather than foreign goods causing the value of imports
to decrease.
According to Borkakoti (1998), the Marshall-Lerner condition is a condition
of stability. If the elasticity of demand for imports is greater than zero by the
same amount as the elasticity of demand for exports is less than one, then the
two elasticity of demand will add up to one. Therefore, the depreciation will have
no effect on the trade balance.
A J-curve as defined by Rose and Yellen (1989) is the combination of a
negative short-run derivative with a positive long-run derivative. A typical J-curve
scenario according to the authors is illustrated as follows: the initial effect of
depreciation is to raise the domestic prices of imported goods, because prices of
export goods are sticky in sellers currencies. There is only a small immediate
impact on the volume of trade flows. Henceforth, the value of exports rises only
slightly, whereas the value of imports rises substantially due to the increased
cost of an unchanged quantity of imports. As a result, the balance of trade in real
terms deteriorates in the short run. As time passes, the increased price of
imports eventually reduces import volume; export volume and value also rise
over time because the price elasticity of foreign import demand is larger in the
long run than in the short run. As a result, the effect is upturned over time
although the depreciation has an initially negative impact on the real trade
balance, resulting to a cumulatively positive effect; thus the short-run response

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is perverse. The graph of the response of the trade balance over time to a onceand-for-all real depreciation resembles a J tilted to the right.
The graph below is authors own interpretation based on Rose and Yellen
(1989).

TB
Trade

t0

Figure 1 Sketch of the J-curve effect, t0 is the time of

depreciation.

2.3.Empirical Literature
Rose (1990) examined the empirical impact of the real exchange rate on
the trade balance on various developing countries. The author used annual data
that covered 30 countries from 1970 until 1988. Besides that, quarterly data also
was used to confirm the annual results. It was discovered that the exchange rate
does not have perverse impact on the trade balance.
Wilson (2001) studies the effect of real exchange rate on the real trade
balance for bilateral trade in merchandise goods for Singapore, Malaysia, and
Korea to the USA and Japan on a quarterly basis over the period 1970 to 1996.
They used partial reduced form model of Rose and Yellen (1989) (as mentioned in
Wilson, 2001) derived from the two-country imperfect substitute model. He found
that there is no significant impact of real exchange rate on the real trade
balance. He also mentioned that there is no evidence for J-curve on Singapore
and Malaysia. Nevertheless, he discovered that there are some J-curve effects for
Korea pertaining to both Japan and the USA. The author mentioned that these
effects might be caused by small country pricing of exports in foreign currency,
however, he found no evidence that imports later fell as the lag length on the

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real exchange rate increased, which would be required to support a strict

interpretation of the J-curve.
Wilson and Tat (2001) studied the relationship between the real trade
balance and the real exchange rate for bilateral trade in merchandise goods
between Singapore and the USA on a quarterly basis over the period 1970 to
1996 using the partial reduced form model of Rose and Yellen (1989) (as
mentioned by Wilson and Tat, 2001). They found that there is no significant
impact of the real exchange rate on the bilateral trade balance for Singapore and
the USA. This is might be due to the fact that there is a weak relationship
between changes in the exchange rate and changes in export and import prices
and volumes for Singapore. Besides that, the authors discovered there is little
evidence of a J-curve effect. It was not clear whether small country pricing by
exporters in U.S. dollars masked J-curve effect from initial rise in import values
when Singapore dollar depreciated.
Another study has been done by previous researcher that explored the
balance of trade model on Indian data from 1960 to 1995 using a reduced-form
specification similar to Rose (1991) (as mentioned by Singh, 2002). The
researcher found that the real exchange rate has significant impact on the trade
balance compared to nominal exchange rate. In addition, balance of trade in
India also being influenced by domestic income. Instead of focusing on nominal
exchange rate, Singh (2002) suggested that policy makers and authorities focus
more on the real exchange rate, specifically the trade weighted real effective
exchange rate.
Petrovi and Gligori (2010) were interested in finding whether and how
depreciation in exchange rate as well as its appreciation affects trade balance in
Serbia, both in the long run and short run which covers from January 2002 to
September 2007. They used Johansen co-integration analysis to investigate the
long run impact of the exchange rate on trade balance together with the
autoregressive distributed lag (ARDL) approach. The error correction model is
used to determine the short term impact and the related J-curve pattern. The
authors found out that in the long run, the exchange rate depreciation does
improves trade balance, whilst in the short run, the depreciation in exchange
rate giving rise to a J-curve effect.
Yusoff (2010) examined the impacts of changes in the real exchange rate
on the real Malaysian trade balance and the domestic output using quarterly
data during the pegged exchange rate regime, 1977:1-1998:2 and the extended
model from 1977:1 to 2001:4 which includes the period of fixed exchange rate
regime. The researcher found that in the long run, depreciation in real exchange
rate improves the Malaysia's trade balance. In addition, there were similarities of
exchange rate impact on the balance of trade as well as the domestic output.
There was a delayed J-curve effect during the 1997:1 to 1998:2, however, no Jcurve effect was found on the short-run analysis.

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3. METHODOLOGY
3.1.Introduction
This section discusses the model and methods of estimation that author
used in order to satisfy the objectives of this study; i.e. determining the
relationship of real exchange rate on balance of trade as well as finding the
existence of J-curve effects between the three countries.
3.2.Data
The annual data for this study is obtained from International Monetary
Fund (IMF) as well as World Bank. The data used constitutes information from
year 1990 until year 2014. There was some striking adjustment in real exchange
rate and trade imbalance. Therefore, this is one of the reasons that support this
research to study whether there is relationship between real exchange rate and
the balance of trade. The trade balance, domestic and foreign incomes are all in
real terms, while the consumer price index (CPI) represents as the price deflator.
3.3.The Model
The modelling on the relationship between exchange rate and trade
balance is discussed by various papers. For this paper, the author specifically
refers to research done by Ng, Har and Tan (2009) as well as Gmez and lvarezUde (2006) which emphasized in exchange rate on bilateral trade balance
evidence.
In general, equilibrium goods market in an open economy can be
explained by the following equations:

Y =C (Y T )+ I ( Y ,r )+G ( Y , ) + X (Y , ) , where:
Y
and

signifies total domestic income,

signifies income tax,

interest rate,
rate,

signifies consumer spending,

signifies government spending,

signifies import,

signifies investment,

signifies export, and

symbolizes as

signifies real exchange

signifies foreign

income.
Consumers spending ( C ) is derived from total income minus income
tax, or in other words the disposal income ( Y T ) . There is positive relationship
occurs between total domestic income and consumer spending due to the fact
that higher disposal income result in higher consumer spending besides to
increase total domestic income.

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Investment ( I ) is a function of total income and interest rate. If there is

an increase in total personal income, people would invest more. Hence, there is a
positive relationship between investment and total income.
On the other hand, interest rate ( r ) imposed might distress investment
decision. It is widely known that lower interest rate attracts more investment as
it reduces cost of capital. In contrast, higher interest rate would decrease total
domestic investment. Thus, it can be concluded that, there is a negative
relationship between investment and interest rate.
The real exchange rate (

) is obtained by multiplying the nominal

exchange rate ( E ) with the foreign price level ( P ) and then divide them by

the domestic price level ( P ). Nominal exchange rate ( E ) is defined as the

number of unit domestic currency exchange for one unit of foreign currency,
giving:

( E P )
(1)
P

Import ( ) is stimulated by domestic income or output ( Y ). There is

a positive relationship between domestic income and import as the higher the
domestic income, the higher the imports. On the other hand, there is also a
negative relationship between import and total domestic income as quantity of
import depends on the real exchange rate ( ). Higher

signifies lower

quantity of imports due to the fact that foreign goods become relatively
expensive.

Export ( X ) depends on the foreign income ( Y

and real exchange

rate ( ). Foreign demand for all goods and services will increase when the
foreign income is high; thus leads to an increase in exports. In contrast, when
there is an increase in real exchange rate, the relative price of foreign foods in
terms of domestic goods also causes export to be increased. Therefore, it can be
reckoned that there is a positive relationship between trade balance, foreign
income, and real exchange rate.
As the objective of this paper is to observe the trade balance (net export:

NX ) and the exchange rate, other variables are assumed constant. The net
export is:

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EX=I M

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(2)

By substituting the function of export and import into equation (2), it shows

NX=X ( Y , ) ( Y , ) (3)
After that, substitute equation (1) into equation (3)

NX =X Y ,

Assume

EP
P

E P
E P
Y ,
( 4)
P
P

) (

is stationary, we can rewrite the equation (4) as

NX =NX ( Y , Y , ) (5)
Equation (6) shows below is the balance of trade as a function of the levels
of domestic and foreign income and the real exchange rate.

ln TB t = 0+ 1 ln Y t + 2 ln Y t + 3 ln RERt +ut (6)

where ln stands for natural logarithm,

process, and trade balance,

TB t

ut

is assumed to be a white-noise

symbolise the ratio of exports to imports

allows all variables to be explained in logarithm form and removes the need for
appropriate price index to explain the trade balance in real term. In this paper,
real exchange rate (

RER t ) is expressed by Malaysian Ringgit (MYR) against

United States Dollar (US$) and

is the gross domestic product of United

States.
The sign of

1 could be either positive or negative, following the

classical theory. There is an increase in Malaysian real income,

increase in import volume if the estimate of
if

Yt

which is

1 is negative. On the other hand,

1 is positive, it means that there is an increase in

Yt

in the production of import-substituted goods. The sign of

due to an increase

2 would depends

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on whether the supply side factors dominate demand side factors. MarshallLerner theory holds when

3 is positive, it indicates that depreciation leads to

the improvement in the Malaysias balance of trade.

This whole process is to be repeated for Thailand and Indonesia data.
3.4.Methods of Estimation
Augmented Dickey-Fuller (ADF) test and Philips-Perron (PP) is the unit root
test that will be used to test the stationary in economic data following the work
of Ng, Har and Tan (2009). Unit root test is used to test of stationary. If ADF test
and PP test show different results, the Kwiatkowski-Philips-Schmidt-Shin (KPSS)
test is used as decisive results. Co-integration analysis is used to determine the
long run relationship between

TB t , RER t ,

Y t and

Y t

in order to solve the

spurious regression problem and violation of the Classical Regression Model.

Three methods are used in order to test for co-integration; i.e. Engle-Granger
Test, Error Correction Model, and Johansen-Juselius Test. In order to know the
disequilibrium error, we rewrite equation (6) as:

ut =ln TB t 0 1 ln Y t 2 lnY t 3 ln RER t (7)

In order to perform Engle-Granger test, the order of integration of the
estimated residual,

ut

should be tested. If there is any co-integrating

regression, then disequilibrium errors in equation (7) should form a stationary

time series, and have a zero mean, the

ut

should be stationary, I(0) with E(

ut ) = 0.
The long run equilibrium may be rarely observed, but there is a tendency
to move towards equilibrium. Thus, Error Correction Model is used to denote the
long-run (static) and short-run (dynamic) relationships between trade balance,
real exchange rate, domestic and foreign income. Vector Error Correction Model
(VECM) is suitable to estimate the effect of exchange rate on trade balance. The
equation (8) represents Error Correction Model as:

lnTB t =lagged ( TB t , RER t , Y t , Y t ) ut 1+ v t (8)

where

ut 1

represents the residual term at

t1 in long term.

Engle-Granger Test and VECM are tests to check whether the long-run
relationship exists in equation only. Following the work of Ng, Har and Tan (2009)

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as well as Gomez and Alvarez-Ude (2006), Johansen-Juselius test will be used to

perform hypothesis tests about the number of the long-run relationship exists in
equation. To use Johansen-Juseliuss method, the Vector Autoregressive (VAR) of
the form needed to turn first,

Z t = 1 Z t1 + 2 Zt 2+ K + k Z tk + v t ,t=1, K , T ( 9)
into a Vector Error Correction Model (VECM), which can be written as

Z t= Z t k + 1 Z t1 + 2 Z t 2+ k1 Z t(k 1) + v t (10)
The test for co-integration between the Z is computed by looking at the

rank of the

matrix via its eigenvalues. The rank of a matrix is equal to the

number of its characteristic roots (eigenvalues) that are different from zero. The
symbol

The vector

shows how many linear combinations of

Zt

Zt

that are stationary.

included of trade balance ( TB ), real exchange rate ( RER ),

domestic income ( Y ) and foreign income ( Y ). Thus,

Z t =[TB RER Y Y ] .

The number of lags is selected based on Akaike Information Criterion (AIC) and
Schwarz Criterion (SIC).
Next, the number of co-integrating equilibrium relationship between the
logarithms of trade balance, domestic and foreign national income and real
exchange rate should be tested following the Johansen-Juselius approach. Two
statistics for co-integration used: the trace statistic,

trace , and the maximal-

max . Both test statistics are the estimated value for the

eigenvalue statistic,

ith ordered eigenvalue from the

matrix. The r set from zero to k 1, where

k = 4 (k represents the number of endogenous variables in this research).

For trace statistic, the test statistic for co-integration is formulated as
g

trace ( r )=T

i=r +1

ln ( 1 ^ i)

where T signifies the sample size, r signifies number of long run relationship
exist, and

represents the eigenvalue. For trace statistic, the null hypothesis

is the number of cointegrating vectors is less than equal to r against an

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unspecified alternative. If

trace

equal to zero, thus, all

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are also equal to

zero, so it is a joint test.

For maximal-eigenvalue statistic, the test statistic for co-integration is
formulated as

max ( r , r +1 )=Tln (1 ^ i)
The null hypothesis for maximal-eigenvalue statistic is the number of cointegrating vectors is r against an alternative of r + 1.
There will be various diagnostic tests to be done before forecasting with
the final model in order to confirm the adequacy of representation of the model.
To test the parameter, the t-test is used. Pairwise Granger Causality Test will be
used to test the direction of causality between two variables. Afterward, in order
to analyse the residual, Portmanteau Autocorrelations (Q) test, Autocorrelation
LM (LM) test, White heteroskedasticity (White), and Jarque-Bera residual
normality test via Cholesky (JBCHOL) and Urzua (JBURZ) factorizations are employed.
Finally, impulse response analysis will be used for forecast purpose because the
analysis tells the information about interaction among the variables in the
system. The impulse response function is then will be used to verify whether Jcurve effects exist in Malaysia, Indonesia, and Thailand.

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4. FINDINGS AND DISCUSSION

Disclaimer: Since there is no econometrical or statistical estimation is
needed for this term paper, the author omits this section.
5. CONCLUSION
This paper will focus on the short run and long run effect of the real
exchange rate on balance of trade of three countries; i.e., Malaysia, Indonesia,
and Thailand in order to test whether Marshall-Lerner condition and J-curve
effects exist. The results obtain are expected to support the empirical literatures
on the Marshall-Lerner condition through VECM, indicating that depreciation does
improves the trade balance. In addition, J-curve effects are expected not to exist
during the short run period.
It is hope that the results obtained from this research study will help the
government and other related bodies to create a policy that focusing on the
variable of real exchange rate, which is the nominal exchange rate to aggregate
price level. This is to ensure that it achieve the desired effects on trade balance.
In addition, the authorities must cooperate between the devaluation-based
policies (affected through changes in nominal exchange rate) and stabilization
policies (to ensure domestic price level stability) to achieve their targeted level
of trade balance.

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