Research On Home Market Effect And China's Terms Of Trade

Terms of trade represent a country's status in international trade, while home market effect reveals the relationship between a country with a large home market and this country's export. Terms of trade and economic growth are related to each other in an dynamic stochastic general equilibrium model through two different effects, namely home market effects (Krugman,1980) and productivity shock effects (Backus, 1991). In home market effects, economic growth results in better terms of trade. However, in productivity shock effects, economic growth results in worse terms of trade.Which of the two effects domain the change of China's terms of trade? It depends on how the production is changed by productivity improvement in economic growth. This paper made a breakthrough to analyze the empirical relations between China's economic growth and the change of its terms of trade from a viewpoint of home market effect while China is catching up US. Based on empirical study of annual data from1981 to 2006, it is found by setting up a simplified vector error correction model that there is a co-integration relation between China's economic growth and the change of its terms of trade. By checking the sign of the matrix defined by the vector error correction model, we found that home market effects prevail in the relations between China's economic growth and the change of its terms of trade.The empirical results implies that China's domestic market has a directing and stimulating effect on China's foreign trade. China, being the "World's Manufacturing Factory", has the competitive strength of scale economy. In the circumtance, this paper advises as follows. On the one hand, we should encourage innovation and diversity to stimulate industy upgrading, thus raise our status in international trade. On the other hand, we should take advantage of our domestic market and raise domestic demands, which eventually promote foreign trade.