The Determinants of Pakistan’s Trade Balance: An ARDL Cointegration Approach

This article is an attempt to examine the short and long-runrelationship between the trade balance, income, money supply, and realexchange rate in the case of Pakistan’s economy. Income and moneyvariables are included in the model in order to examine the monetary andabsorption approaches to the balance of payments, while the real exchangerate is used to evaluate the conventional approach of elasticities (MarshallLerner condition). The bounds testing approach to cointegration and errorcorrection models, developed within an autoregressive distributed lag(ARDL) framework is applied to annual data for the period 1970 to 2005in order to investigate whether a long-run equilibrium relationship existsbetween the trade balance and its determinants. Additionally, variancedecompositions (VDCs) and impulse response functions (IRFs) are used todraw further inferences. The result of the bounds test indicates that thereis a stable long-run relationship between the trade balance and income,money supply, and exchange rate variables. The estimated results show thatexchange rate depreciation is positively related to the trade balance in thelong and short run, consistent with the Marshall Lerner condition. Theresults provide strong evidence that money supply and income play a strongrole in determining the behavior of the trade balance. The exchange rateregime can help improve the trade balance but will have a weakerinfluence than growth and monetary policy.