Essay: Why industrial countries decided to float their currencies in 1973

In March 1973 when most industrial countries decided to float their currencies, it was believed that exchange rate flexibility would take care of trade deficits and isolate countries from perturbances originated abroad so that they could utilize fiscal and monetary policies to better manage their economies. The credence was mostly predicated on the fact that import and export demand elasticity are high enough to warrant amendment in the trade balance due to currency depreciation. Once the lags are realized, eventually the trade balance ameliorates. Since such a short-run pattern resembles the letter J, it is kenned as the J-Curve phenomenon in the literature. In discussing the theoretical background for the J Curve Hypothesis, let us first define exchange rate. Exchange rate is the value of a given currency expressed as a proportion of another currency.
Economist links authentic exchange rate with trade balance by theory called J-Curve theory. The exchange rate depreciation worsens the trade balance in short-run where in long-run the trade balance amends. The effect of exchange rate depreciation in such pattern is not linear rather J-shaped, hence called J-shaped Curve theory. The trade balance worsens immediately to depreciation because the imports are more costly as their prices are paid in peregrine currency. The export becomes frugal due to depreciation. The immediate price effect cause to worsen the trade balance in short run, however, after some time (in long run) the domestic and peregrine engenderer and consumer respond to price change and thus the prices are adjusted and trade balance ameliorates. If there is currency appreciation the whole mechanism will reverted and it will compose the inverted J-curve. Following the depreciation of currency, the volume of imports and exports will remain level due in part to pre-subsisting contracts for imported goods that have to be accoladed. When depreciation occurs the import prices elevates and export falls. The value of import increases in comparison to export value. Thus trade balance is worsened in short run. In short run the consumer pays high prices for imported goods. This is due to the fact it take time to probe the felicitous, acceptable and more frugal products. In this scenario the ordinant dictation for extravagant products becomes inelastic as well. Keeping other things constant, the trade balance and balance of payment turns in deficit in short run if the depreciation occurs. In the long run the depreciation amends the trade balance because of shift in demeanor of domestic consumer and engenderer. They commenced to purchase their own engendered goods in lieu of purchasing the highly priced imported goods.
There are two ways to express exchange rate. One is as the number of peregrine currency units per unit of domestic currency, for example, 105 ¥/$1. The other is the number of domestic currency units per unit of peregrine currency, for example, $1.40/€1. The latter expression is the American style, and will be utilized for the purposes of this work. When the exchange rate is transmuted (verbalize incremented), the domestic currency loses value, causing exports to become more frugal for the rest of the world because peregrine currency simultaneously gains value. Exports are consequently expected to go up. Likewise importers are expected to decline as the rest of the world’s goods and accommodations become more sumptuous for domestic denizens. Thus, the balance of trade (BOT) should increment
However, Alfred Marshall and Abba Lerner argued that an incrementation in exchange rate can lead to a BOT surplus only if elasticity of injuctive authorization for exports by the rest of the world, and similarly demand for imports by domestic denizens, are vigorous enough. They engendered the following test to determine whether the elasticity are vigorous enough:
1. The number of supersessions for the good. If there is an immensely colossal number of a supersession available, the elasticity will be high, whereas the elasticity will be low if there is a minuscule number of a supersession available.
2. Time passed after the vicissitude in exchange rate. The longer the time passed after the transmutation in exchange rate, the higher the elasticity.
Pakistan is facing balance of trade and balance of payment deficit quandaries since its independence. Policy maker has endeavored sundry policies to amend the trade deficit quandary. But the policies do not engendered the promising results. Now a day Pakistan has entered into floating exchange rate system and other free trade acquiescents with sundry countries with the hope to amend the trade deficit quandary. Felicitous investigation in required to check whether the floating exchange rate policy will work for Pakistan to amend trade? Economist links authentic exchange rate with trade balance by theory called J-Curve theory. The exchange rate depreciation worsens the trade balance in short-run where in long-run the trade balance amends. The effect of exchange rate depreciation in such pattern is not linear rather J-shaped, hence called J-shaped Curve theory.
The trade balance worsens immediately to depreciation because the imports are more costly as their prices are paid in peregrine currency. The export becomes frugal due to depreciation. The immediate price effect cause to worsen the trade balance in short run, however, after some time (in long run) the domestic and peregrine engenderer and consumer respond to price change and thus the prices are adjusted and trade balance amends. If there is currency appreciation the whole mechanism will reverted and it will compose the inverted J-curve. Following the depreciation of currency, the volume of imports and exports will remain level due in part to pre-subsisting contracts for imported goods that have to be venerated. When depreciation occurs the import prices elevates and export falls. The value of import increases in comparison to export value. Thus trade balance is worsened in short run. In short run the consumer pays high prices for imported goods. This is due the fact it take time to probe the congruous, acceptable and more frugal products. In this scenario the ordinant dictation for extravagant products becomes inelastic as well. Keeping other things constant, the trade balance and balance of payment turns in deficit in short run if the depreciation occurs. In the long run the depreciation amends the trade balance because of shift in demeanor of domestic consumer and engenderer. They commenced to purchase their own engendered goods in lieu of purchasing the highly priced imported goods. The authoritative ordinance for export increases and imported goods are purchased at lower volume. The deportment of peregrine consumer and engenderer is something different. They purchase the imported goods rather utilizing their own products as the imported goods (for peregrine country) are frugal until the equilibrium condition is reached.
Our study will enables us to ken the impact of depreciation on trade balance. The Pakistan has adopted the floating exchange rate system where the prices are resolute by the supply and authoritatively mandate forces. Further the free trade acquiescents have been made with sundry countries in order to import the industrial equipment to enhance the capacity and quality of domestic products and boost export with trading partners. The aim is to explore the incipient market as well. Our study will enable us to find performance of free trade and floating exchange rate policy. It will additionally enable us how for this policy is prosperous in ameliorating the trade balance. Should Pakistan fixate on the current trade partners or to explore the incipient market for their exports? Furthermore, we will able to answer the question about the subsistence of J-curve pattern in trade balance of Pakistan.
Value of Pak rupee against US $ has been on perpetual decline since last three decades. Official exchange rate of PKR declined from PKR 10/$ in 1980 to PKR 90/$ in 2011. The exchange rate system adopted by Pakistan is floating depending on market conditions; however, it is frequently adjusted in hope of amending balance of trade. The following two arguments are presented to justify the currency depreciation:
1. Currency devaluation switches the consumption of goods from peregrine goods to domestic goods. By currency devaluation, the peregrine goods become extravagant, ergo, the people switch from the consumption of peregrine goods to the domestic goods. Similarly, the local goods will become more frugal for the foreigners and the export will elevate. This will amend the trade balance and will promote the local engenderment of goods.
2. The devaluation of mazuma will reduce the authentic value of mazuma balance and will amend authentic price of the traded and non-traded goods, thus, the trade of goods and accommodations will ameliorate.
The most vigorous argument in favor of currency depreciation is soi-disant J curve phenomenon. The J curve phenomenon states that when value of local currency goes down as compared to peregrine currency, the exports become more frugal and imports become sumptuous. This phenomenon causes trade deficit in the short-run since the import bill increases by extravagance of peregrine currency. However, eventually the domestic goods become more competitive in the international market due to which peregrine authoritative ordinance of local goods increases, bringing an amendment in the trade balance.
Many researchers have studied the J-curve phenomenon since a long back. The evidence that emerge in the view from the literature is rather commixed. While, Ng, Har and Tan(2008) and Umoru and Eboreime (2013) found no evidence of J-curve phenomenon, Gupta-Kapoor and Ramakrishnan (1999), Bahmani-Oskooee and Kantipong (2001) and Petrovic and Gligoric (2010) found little evidence of such phenomenon. Still, Ahmad and Jing (2004), Baek, Mullik and Koo (2006) and Hsing (2008) found a commixed result.
Gupta-Kapoor and Ramakrishnan (1999) have empirically tested the J-curve phenomenon utilizing quarterly data for Japan between 1975:1 and 1996:4. The effect of an appreciation of yen on the ratio of imports to exports (M/X) was analyzed utilizing an error rectification model. The impulse replication function betokened that the J-curve phenomenon was found to be true for Japan during the flexible exchange rate regime.
Bahmani-Oskooee and Kantipong (2001) investigated the J-Curve phenomenon between Thailand and her immensely colossal trading partners that included Germany, Japan, Singapore, U.K and the U.S. Utilizing quarterly data over 1973I-1997IV period and co integration analysis they found the evidence of the J-Curve at least in the cases of U.S. and Japan.
Utilizing co integration and causality tests the paper by Ahmad and Yang (2004) has endeavored to ascertain the long-run relatedness, and the short-run dynamics, between the authentic exchange rate, national income, and the trade balance utilizing time series data on China’s bilateral trade with the G-7 countries. The paper found some evidence that an authentic depreciation eventually amended the trade balance with some countries. But there was no denotement of a negative short-run replication which characterizes the J-curve.
Utilizing autoregressive distributed lag (ARDL) model the study by Baek, Mullik and Koo(2006) examined the J-curve phenomenon for the U.S. agricultural trade and compared the effect on agricultural trade relative to the U.S. non-agricultural trade. For this purport, bilateral trade data between the U.S. and her three major trading partners _ Japan,
Canada and Mexico had been utilized. The study found little evidence of the J-curve for the U.S. agricultural trade with Japan, Canada and Mexico. For the non-agricultural trade, on the other hand, the comportment of the U.S. trade with industrialized economies such as Japan and Canada followed the J-curve, but not with developing economies such as Mexico.
The study by Hsing (2008) found the evidence of a J-curve for Chile, Ecuador, and Uruguay. However, there was lack of fortification for a J-curve for Argentina, Brazil, Colombia, and Peru.
The paper by Ng, Har and Tan (2008) endeavors to identify the relationship between the authentic exchange rate and trade balance in Malaysia from year 1955 to 2006 by utilizing Unit Root Tests, Co integration techniques, Engle-Granger test, Vector Error Rectification Model(VECM), and impulse replication analyses. The study found a long run relationship between trade balance and exchange rate. However, it failed to designate any J-curve effect in Malaysia case.
The paper by Petrovic and Gligoric (2010) showed that exchange rate depreciation in Serbia ameliorated the trade balance in the long run despite it established a J-curve effect in the short run. Johansen’s co integration approach, autoregressive distributed lag approach, error rectification models as well as impulse replication functions were acclimated to arrive at the conclusion.
Umoru and Eboreime (2013) have utilized the Bounds testing approach on time series data of over 40 years to explore the J-curve phenomenon on the Nigerian oil sector. However, this study reached at the conclusion that the standard J-curve hypothesis could not be validated for the Nigerian oil sector as the trade balance contemporaneously gained the amelioration in the short-run.
TB= β0+ β1 Rt_i+β2 Yp_t+ β3 〖Yi〗_t+ε_t
Where the quantification of trade balance is the ratio of Pakistani exports to the ith trade partner (xit) over her imports from the ith trade partner (mit); ypt is Pakistan’s income, and yit is the income of the respective trading partner i., rit is the authentic bilateral exchange rate between Pakistan and trading partner i (an incrementation implicatively insinuates depreciation). The depreciation of the Pakistani rupee against the trading partner’s currency could have a positive or a negative impact on the trade balance, depending upon the nature of exports to, and imports from the trading partner i.e. β1 >0 or β1 <0 . If an incrementation in domestic income raises imports, the estimate of β2 would be expected to be negative; on the other hand, if an incrementation in ypt is due to an incrementation in the engenderment of import-sub statute goods, then it is possible that the relationship between domestic income and the quantification of the trade balance is positive. Similarly, the estimated value of β3could be either negative or positive.
The purport of this study to analyze the short-run and long-run relationship between exchange rate and trade balance of Pakistan and her trading partners. Panel Data will utilize from 1990 to 2015. Data will amass from IFS , WDI , PBS etc.
First step in the estimation process involves testing all the variables for stationary by conducting unit root tests. If a unit root is found in a variable it is labeled as non-stationary and some transformation must be applied to make it stationary. In order to test the for the presence of stationary in the variables Augmented-Dicky-Fuller(ADF) test will apply. If the variables have unit roots then it is feasible to test for the subsistence of long-run relationship between the variable by applying co-integration test. The purport of co-integration test is to determined whether a group of non-stationary series is co-integrated. For this purport the Johansen (1988) procedure is applied which employs a maximum likelihood procedure for the estimation and tenaciousness of the presence of co-integrating vectors in ARDL. For the detection of short-run and long-run relationship will utilize the Error Correction Model (ECM).