Dynamic analysis of trade balance behavior in a small open economy: the J-curve phenomenon and the Czech economy

This paper focuses on empirical investigation of the J-curve phenomenon in the Czech economy. There are emphasized some problem areas of past research and suggested, from our point of view, better practices. The entire analysis is framed within the context of a small open economy. Using aggregate quarterly data for the period 2000–2014, we find that the real effective exchange rate has a strongly negative effect on trade balance in the short run; this effect is, however, replaced with a positive one in the long run, thus confirming the J-curve phenomenon. It follows from the computed impulse-response functions that a positive effect can occur as early as the second quarter. Alternatively, if depreciation or devaluation is perceived by economic agents as permanent, the improvement in the trade balance arrives with a time delay (ranging from 2 to 3 years). Besides domestic and foreign income, domestic and foreign interest rate were also chosen as explanatory variables with an intention to incorporate international borrowing and lending. It has been shown that the intertemporal substitution represents a marginal factor for the trade balance determination. Conversely, domestic economic growth exhibits a significantly greater influence.