Trade Liberalization and Real Exchange Rate Movement

Although theory suggests that the real exchange rate should depreciate after a permanent trade liberalization but could appreciate temporarily with a transitory one, little empirical evidence exists. Unlike existing studies that use either indirect tests or openness measures that could be unreliable, this paper uses an event study based on individually documented trade liberalization in 45 countries. The result shows that real exchange rates depreciate after countries open their economies to trade. In countries with multiple liberalization episodes, however, real exchange rates do not depreciate at the start of trade liberalization in early episodes, suggesting that partial or transitory trade liberalizations deter adjustments toward the equilibrium exchange rate.