Exchange rate and trade balance linkage: evidence from Malaysia based on ARDL and NARDL

The exchange rate is able to influence the trade balance in most of countries’ economy. When a country's trade account does not net to zero – that is, when exports are not equal to imports – there is relatively more supply or demand for a country's currency, which influences the price of that currency on the world market. However, the relationship between exchange rate and trade balance is indecisive both in long run and short run. The purpose of this paper is to examine the relationship between exchange rate and trade balance in Malaysia. This study extends prior literature by using a more recent monthly time series data and relatively advanced techniques known as ARDL and NARDL. Based on this study, it is found that the relationship between these two variables exists. It also found that trade balance is worsened in the short-run in line with the J-curve theory. These results imply that there is a trade-off of depreciation between short-run and long-run, and between exporting sectors and importing sectors. Policymaker could moderately depreciate the currency to boost trade balance but needs to effectively manage the cost incurred.