The short-run and long-run trade balance response to exchange rate changes in Malawi

The objective of this paper has been to examine the short-run and long-run effects of real exchange rate changes on the trade balance in Malawi. The model was estimated using the multivariate cointegration framework proposed by Johansen (1988). The results from the study show that the impact of a real depreciation on the trade balance is not significant enough to change the trade pattern in the long-run. Further, while a J-curve pattern is observed in the short to medium term, the improvement that follows a deterioration is not significantly different from the old equilibrium levels. On the other hand, the trade balance seems to respond more positively to shocks in domestic income. These findings have important policy implications for policy-makers. The long-run insignificance of the real exchange rate movements on the trade balance and the importance of domestic income in determining trade patterns suggest that policies aimed at improving the country’s trade competitiveness should first focus on internal supply-side policies that give a conducive environment for the production of exportables and import-substitutes. Focusing on the external approach (that is, currency devaluation) may not bring effective results as Malawi is mostly a price-taker on the international market, and would thus not be able to influence external demand for her exports through price incentives that arise from exchange rate changes.