Sensitivity of Trade Balance to Exchange Rate Depreciation: Evidence from Indo-U.S. Bilateral Trade

Abstract

The fundamental economic theories presume a relationship between exchange rate and trade balance that depreciation in the exchange rate would affect trade balance. Magee (1973) formulated a hypothesis that for a given currency devaluation or depreciation, the trade balance reacts differently in short run and long run. It has been argued that with the depreciation of domestic currency the trade balance deteriorates in the short run and improves in the long run leading to J-shaped pattern of response. Since then some studies have empirically investigated the J-curve hypothesis with mixed results. The theory is hardly tested to Indian scenario. The present study, hence, examines the nature of response of India’s trade balance to exchange rate shocks. The study specially focuses on the response of India’s bilateral trade with U.S for continuous depreciation of Indian rupee against U.S dollar. The study uses monthly data for the period from 2009 to 2017. Using the VAR methodology, the Impulse Response Function has been fitted and the results do not have evidence for J-curve pattern of trade balance rather it appears to be ‘inverted J-curve’.