Trade Balance, Terms Of Trade And Real Exchange Rate

The paper analyzes the influence of the RMB real exchange rate on the Sino-US trade balance based on the decomposition of the real exchange rate. Whether it is from absorption approach which is based on partial equilibrium analysis or elasticity approach which is based on general equilibrium analysis, previous theoretical researches and empirical studies on the exchange rate fluctuations analysis revealed that the effect of real exchange rate fluctuations on trade balance adjustment is uncertain. Therefore, from the real exchange rate determination theory, the real exchange rate fluctuations can be derived from the deviation from law of one price of tradables and the relative prices of tradables and non-tradables (Balassa-Samuelson effect), The real exchange rate can be decomposed into external and internal real exchange rate, reflecting the impact of nominal and real shocks respectively. With this decomposition, the paper compares the different influences on trade balance because of real exchange rate changes caused by the nominal and real shocks.Furthermore, according to the definition formula of the real exchange rate, the paper decompose the terms of trade from the internal real exchange rate such that we can have a better insight of the trade effects of real exchange rate fluctuations caused by the determinants.In this paper, the empirical analysis takes Sino-US trade data from January 2010 to March 2014 to establish both undecomposed and decomposed regression models. By comparing the results of the two models, it reveals that the decomposed real exchange rate can explain the trade imbalances better than the undecomposed. The result of the decomposed regression model shows that the influence of real exchange rate on the Sino-US trade balance has time lag effect and it comes from both deviation of law of one price and BS Effect. But BS effect plays a relatively major role in comparison to the contribution of the deviation from law of one price of tradables This study further introduced the terms of trade as one of the determinants of the real exchange rate into the decomposition model, and the result shows that it would be most convinced to have three determinants of real exchange rate in the model, and relative changes in the terms of trade of the two countries have a significant impact on the trade balance, but the impact also has a time lag.