Adjustment of external imbalances: Does the exchange rate matter? -- evidence from Brazil, China and India
Date
2011
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Publisher
University of Delaware
Abstract
This thesis investigates the nature of the dynamic relationship between external balances and exchange rate dynamics in a macroeconomy. Specifically, this study focuses on how various measures of external balances serve as economic buffers to mitigate the effect of exchange rate shock to the economy. It examines the dynamic relationship between external balances and exchange rate shock via the application of cointegrated vector autoregression method and innovation accounting with generalized impulse responses and forecast error variance decompositions. The data sample spans the period 1986-2008 and includes three important developing countries: Brazil, China and India. Empirical evidence shows that for China and India, understanding of the exchange rate dynamics is helpful in predicting the movement of external balances. But for Brazil, the reverse path is true. Results of generalized impulse responses suggest that external balances demonstrate a predictable and systematic pattern after a one-time exchange rate shock. Specifically, the results indicate that exchange rate shock generates a positive response in current account adjustment and has a negative impact on capital gains. The latter soon gives rise to a small drop in current account balance due to temporary income shock and capital mobility. Taking account of the overall current account and capital gains adjustment (one positive and one negative), change in net foreign assets (NFA) position is largely cushioned from exchange rate shock. Integrating the results of generalized impulse responses and Granger causality tests, it is easy to find that there exists a feedback mechanism which significantly contributes to the adjustment of external imbalances. Moreover, terms of trade and domestic productivity serve as transmission channels which play a critical role in the system. From a policy perspective, in coping with enlarged global imbalances, exchange rate as well as terms of trade and domestic productivity should receive more attention in policy decisions to stabilize the economy.