Determinants of Malaysian Trade Balance: An ARDL Bound Testing Approach

Abstract

This paper examines the short- and long-run relationships between trade balance, real exchange rates, income and money supply in the case of Malaysia. The inclusion of income and money variables in the study is purposely to examine the monetary and absorption approaches to the balance of payments beside the conventional approach of elasticity, using exchange rates. Using the bound testing approach to cointegration and error correction models, developed within an autoregressive distributed lag (ARDL) framework, we investigate whether a long-run equilibrium relationship exists between trade balance and the determinants. Additionally, we adopt an innovation accounting by simulating variance decompositions (VDC) and impulse response functions (IRF) for further inferences. Using this approach, we find evidence of a long-run relationship between trade balance and income and money supply variables but not between trade balance and real exchange rate. The findings also suggest that Marshall–Lerner condition does not hold in the long-run for Malaysia and for policy wise the Malaysian trade balance/balance of payments should be viewed from absorption and monetary approaches.

Keywords:

• Trade balance
• cointegration
• ARDL
• variance decompositions
• impulse response functions

Notes

1. Increase in real exchange rate index represents revaluation of Ringgit Malaysia (RM) vice versa.

2. Pesaran and Pesaran (1997) and Pesaran et al. (2001), however, generated critical values based on 500 and 1000 observations and 20,000 and 40,0000 replications, respectively, which are suitable for large sample size.