Trade balance and the real exchange rate: an analysis of cointegration

Abstract This paper utilizes the methodology of co-integration to test the theoretical proposition that there is a long run relationship between the trade balance and the real exchange rate. Several of the commonly used definitions of the real exchange rate were tested but none showed co-integration with the trade balance. The only measure of the real exchange rate that was co-integrated with the trade balance was the one defined by the relative price of tradeables and non-tradeables. The evidence is not inconsistent with the observation that the direction of causality runs from the real exchange rate to the trade balance.