Dynamics of Co-integration: A Story from United Kingdom`s Economy

Exchange rate is a significant factor in international macroeconomics; it affects are witnessed in the recent past on different currency crises in many economies and has attracted focus of policy makers around the globe. But the question is can the exchange rate policy really be used to influence trade flows? Whether we really can say what effect on trade balance a depreciation or appreciation of exchange will have? Is the connection between exchange rate, trade balance and balance of payments is strong enough for us to be able to base a policy on it? So, this research study focuses on the above questions for United Kingdom (UK) economy. Data of defined variables is collected on annual basis for thirty one years. By applying cointegration, it is estimated that there exist a long run relationship. UK has significantly and correctly signs the short run dynamic. Exchange rate does not Granger cause balance of payment and balance of payment does not granger cause exchange rate. In conclusion, we found that determinatnts of balance of trade affect the exchange rates, also, these rates have an considerable effect (positive or negative) on balance of payments.