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Appendix I. Data Appendix
Appendix II. Derivation of the Formula for the Elasticity of the Trade Balance Vis-à-vis the Real Exchange Rate
This work was initiated as part of the Middle East and Central Asia Department’s work on exchange rates. We are very grateful to Rakia Moalla-Fetini for in-depth discussions and support throughout the project, Abdul Abiad, Klaus Enders, Aasim Husain, Mohsin Khan, Jaewoo Lee, Sam Ouliaris, and Juan Zalduendo for discussions and comments, and Kaz Sakamoto for excellent research assistance.
The trade balance is defined in the paper to cover trade in goods and nonfactor services.
An alternative approach to obtain the overall trade balance REER elasticities that is not explored in the paper is to estimate regressions of the overall trade balance to GDP ratios of individual countries on the REER.
See, for example, Goldberg and Knetter (1997), and Frankel, Parsley, and Wei (2005). A number of explanations have been put forward for incomplete exchange rate pass-through, including factors such as market segmentation (pricing to market), the presence of nominal rigidities and local currency pricing, and local distribution costs (see e.g. Choudhri, Faruqee, and Hakura, 2005).
Prima facie, it would seem more straightforward to relate changes in import and export volumes directly to changes in the REER. In fact, this is the approach followed by CGER which applies estimation results from Isard and Faruqee (1998) based on MULTIMOD. However, this paper does not follow this approach because it fails to yield robust direct estimates of the REER elasticities for the sample of Middle East and Central Asia countries.
There is not always a one to one relation between real exchange rate changes and relative prices (see the discussion in Section IV).
While the assumption that the price of oil is set in international markets implies that foreign demand should only affect market price, the latter is included in the export volume equation to capture the possibility that the oil exporters face a downward sloping demand curve, in which case demand may not be fully reflected in the price and the output of partner countries could have an effect on the export supply response (see IMF (2006b)).
This implies that a 1 percent increase in the local-currency price of imports relative to non-tradables reduces the volume of imports by 0.66 percent in the long run.
The relative non-oil export price variables are restricted to be the same for the two country groups since an estimation distinguishing between the oil and non-oil exporting countries suggests no significant difference in the price response of non-oil exports.
There is also an additional effect from non-oil exports that is not shown here.
If the share of imports in GDP is larger than the share of exports in GDP, a real depreciation will worsen the trade balance to GDP ratio.
The idea here is that the export to GDP ratio is larger than the import to GDP ratio and both import and export prices are set in foreign currency. Therefore, when the exchange rate appreciates, oil export and import volumes do not change, but the fall in the local currency price of exports will have a larger effect than the fall in the local currency price of imports since exports constitute a larger share of GDP.
It can be argued that the oil-exporting Middle East and Central Asia countries, particularly the GCC countries and other OPEC members, have pricing power in the oil market. However, even if we were to assume that oil exporters have market power, the implied trade balance relation would suggest that a real appreciation of the domestic currency could have a positive effect on the trade balance or a smaller negative effect than is suggested by the estimates in Table 6 to the extent that the demand for oil is inelastic.
The complete derivation of equation (6) is shown in Appendix II. From equation (5), it is clear that the relative prices of imports and exports are defined in terms of ratios to the GDP deflator (
The estimates derived in the paper are consistent with this condition: 0.42*(1-0.67)-0.71*(0.66-1)=0.38.
REERs based on consumer price indices are obtained from the IMF’s Information Notice System for each country in the study where the data is available.
Outliers (defined as countries which have very large and/or incorrectly-signed long-run price elasticities with respect to the REER) are dropped from the sample.
By definition, oil exports are priced in foreign currency.
It is easy to see that –1+μX represents the change in the relative price of exports to domestic output by recalling that the relative price of exports to domestic output is equal to the relative price of exports to foreign output divided by the RER.