Exchange rate and trade balance: a new approach using big mac index for the case of Thailand

Abstract

This thesis focuses on achieving two main objectives: (i) an evaluation of the Thailand’s currency to confirm whether a currency is over- or undervalued during the period from 1980 to 2013 for the case of Thailand; and (ii) a consideration of the effects of a currency’s devaluation on trade balance for the case of Thailand. In this study, these effects are considered in different aspects such as the determinants of a trade balance of Thailand; and the long run relationship between bilateral exchange rate and Thailand’s trade balance. In relation to the first objective, the prominent feature of the study is to use the Big Mac Index (BMI), the first ever study of this kind conducted in Vietnam, for evaluating Thailand’s currency and to apply this evaluation in the context of the link between exchange rate and trade balance. Nevertheless, the common-used index, the Consumer Price Index (CPI), is also utilized to compare the effectiveness of BMI with that of the CPI. Theoretical grounds for evaluating a currency in term of purchasing power parity (PPP) theory are first presented, together with the theory of the link between currency’s devaluation and trade balance. Next, the empirical studies associated with such theory are discussed. Empirical models and results are reported accordingly. To obtain the first objective, the PPP hypothesis is required to be satisfied in terms of panel cointegration tests. The fully modified OLS (FMOLS) technique is adopted to determine the equilibrium exchange rate for evaluation process. On the grounds of the tests of PPP, the panel-based unit root tests as developed by Breitung (2001) and the panel cointegration tests by Pedroni (1999, 2001, 2004) and Kao (1999) are adopted. The empirical results confirm a solid validity of PPP for the case of CPI-based exchange rate and a weak evidence of the PPP for BMI-based exchange rate. In the relation to evaluate Thailand’s currency, the results illustrate that (i) the valuation of Thailand currency using CPI-based exchange rate is fairly consistent to that of BMI-based exchange rate with an exception of the outcomes during the 1997 Asian financial crisis; and (ii) the Big Mac exchange rate is better when bilaterally evaluating the Thailand Baht to US dollar. The second main objective - a consideration of the effects of a currency’s devaluation on trade balance - could be achieved by the two procedures. The first procedure is to analyze how changes on exchange rate policy, fiscal policy, and monetary policy affect Thailand’s trade balance. In this task, effects of devaluation on trade balance are examined on various scenarios: (i) the entire sample of 62 countries who are trading partners with Thailand; (ii) different geography (between regions and regions of countries); (iii) different income levels; and (iv) during different periods in which Thailand’s currency is over- or under-valued. Both OLS method and IV technique are employed because of an endogeneity problems as mentioned in previous studies. The empirical findings indicate that the exchange rate policy plays a central role in explaining Thailand’s trade balance and the fiscal and monetary policies are beneficial in some cases. The second procedure is to examine the long run relationship between a devaluation of Thailand’s currency and trade balance with the applications of the panel-based co-integration tests by Pedroni (1999, 2001, 2004) and Kao (1999) and the FMOLS model. The panel FMOLS estimations illustrate that a devaluation of Thailand Baht could provide positive effects on trade balance in the long run, especially for the groups of country with high income, upper middle income, in America, and Europe. The individual FMOLS regressions between Thailand and each of her 62 trading partners indicate that the devaluation of Thailand’s currency would stimulate Thailand’s trade performance with over 20 trading partners, but hurt its performance with the other 10 countries and inconclusive conclusion for the others.