The Impact of Trade Openness on the Real Exchange Rate and Trade Balance

In our paper, we demonstratethat positive country-specific output and money supply shocks depreciate the real exchange rate and improve trade balance when the preferences across countries are home-biased (that is, when the degree of trade openness is low) and relative risk aversion of CRRA utility is greater than the elasticity of substitution across countries (that is assumed 1 in our model) in the NOEM model of inter-temporal CRRA utility optimization. In this setting, we also show that the increase in trade openness reduces the extent of real depreciation and the magnitude of trade surplus. Moreover, we tested aforementioned hypotheses empirically on the quarterly data of 19 OECD countries from 1973:Q1 through 2010:Q1 employing panel estimation by seemingly unrelated regression. In the benchmark regression, results for trade balance turned out satisfactory, whereas those for the real exchange rate are not. In the sub-period from 2000:Q1 through 2010:Q1, all the coefficients are in the anticipated direction and statistically significantat 1% significance level. Under floating regimes, all the coefficients except those on output expansion and its interaction term are in the anticipated direction and statistically significant at 10% significance level.