Real Exchange Rate Effects on the Balance of Trade: Cointegration and the Marshall-Lerner Condition

A typical finding in the empirical literature is that import and export demand elasticities are rather low, and that the Marshall-Lerner (ML) condition does not hold. However, despite the evidence against the ML condition, the consensus is that real devaluations do improve the balance of trade, though after a lag because of J-curve effects. The aim of this paper is to try and measure the effects of the real exchange rate on the balance of payments using structural cointegrating vector autoregressive distributed lag (VARDL) models for domestic and foreign output, the balance of trade and the real exchange rate. Small systems are estimated for eight OECD countries to investigate long-run cointegration. Generalized impulse response functions are calculated to investigate the response to shocks. These show evidence of J-effects. The VARDL estimates suggest a single cointegrating vector and that output and the real exchange rate can be treated as weakly exogenous for the parameters of the balance of payment equation. This allows estimation using a single-equation ARDL. Although there is considerable heterogeneity, overall the results suggest that the ML condition is satisfied in the long run. Copyright @ 2001 by John Wiley & Sons, Ltd. All rights reserved.