| This dissertation is first of its kind in analyzing the relationship between devaluation and the trade balance in Nepal's economy. As a part of the Structural Adjustment Program in the early 1980s, the Nepalese government devalued its currency several times, but Nepal's real trade balance hasn't shown any major improvement.; Several research methodologies, such as variance decomposition, impulse response function, the Johanson method, the ARDL, and the FM-OLS, are used to analyze the short-term and long-term effects of devaluation. The analysis of short-term and long-term effects of devaluation sheds light on a number of important issues. (i) In the short-run, the majority of variance in trade balance is due to its own innovation, while little comes from the innovation in variables such as effective real exchange rate, money supply and income. (ii) The long-run results are more revealing than the short-run results. The long-run results indicate: first, the relationship between the effective real exchange rate and trade balance is negative and mostly significant; second, domestic money supply plays a strong negative role to trade balance as compared to domestic GDP; third, foreign variables (income and money supply) play a lesser role in improving Nepal's trade balance. (iii) The impulse response function clearly distinguishes the responses of trade balance between one standard deviation shock in both the effective real and nominal exchange rates. The results suggest that prices adjust within a shorter rather than longer period.; To sum up the results, either inconclusive (short-run) or negative (long-run) relationships between effective real exchange rate and trade balance raise doubts about the usefulness of devaluation for Nepal's economy. As Krugman and Taylor (1979) suggest, policies other than devaluation, such as the encouragement of private investment through subsidies, can more effectively improve the balance of trade. Therefore the Nepalese government should focus on further economic reforms, decentralization, and effective growth-oriented macroeconomic policies to improve the trade balance rather than continuing to devalue its currency. |
