Balance of Trade and Exchange Rate: An Econometric Investigation into the J-Curve Phenomenon in Ghana

Isaac Bentum-Ennin

The Icfai Journal of Applied Economics, 2008, vol. VII, issue 2, pages 31-49

Abstract: This study analyzes the responsiveness of the balance of trade to changes in real exchange rate. It also examines the time pattern of this response in order to verify the existence of the J-Curve phenomenon in Ghana. The Johansen multivariate cointegration method employed reveals that trade balance, real exchange rate, domestic real income, income of the rest of the world and money supply have a stable long-run relationship. Consistent with international trade theory, the study also finds that real exchange rate has a positive long-run relationship with trade balance, which means that devaluation/depreciation leads to improvement in the trade balance. Graphical representation of the generalized impulse response function reveals a J-Curve effect. This implies that, just as international trade theory stipulates, devaluation/depreciation initially deteriorates the trade balance but improves it later. The study also reveals that money supply has been the only contributing factor to the deterioration in the trade balance during the sample period, and therefore tight monetary policy measures are recommended.

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