The United States recently announced a 25 percent and a 10 percent tariff on the import of steel and aluminum respectively with an objective to lower its trade deficit with some of its trading partners. A tariff on imports impacts both the importing and the exporting countries. In importing nations, a tariff on imports raises their domestic price, thereby lowering their imports and leading to the improvement in the country’‘s trade balance in the long run. In the short run, however, since it takes consumers to adjust their demand to a change in price, a tariff led price increase of an importable only increases import bills leading to a worsening of the nation’‘s trade balance. This short-run worsening followed by a long-term improvement of trade balance caused by a depreciation of domestic currency produces what is called the J-curve effect. If this phenomenon exists then an improvement in U.S. trade balance with steel and aluminum exporting countries may lead to the appreciation of the U.S. dollar against their currencies resulting in an inverse J-curve effect, meaning a short-run improvement and a long-term deterioration of U.S. trade balance with those countries.
We examine the J-curve effect on the trade between the U.S. and India. Our dependent variable is XTM measured as U.S. export to India over U.S. import from India, and the independent variables are URGDP (U.S. real GDP), IRGDP (India’‘s real GDP), RREX (the U.S. dollar’‘s real exchange rate defined as the number of U.S. dollar needed to purchase one Indian rupee, INR) after adjusted for U.S. relative inflation rate). Our study covers the data from 1992 to 2016. Since our model variables are found to be I(1), we conducted a cointegration test. Both the Rank test and the Max-Eigen Value test allowed us to estimate a vector error correction model (VECM). The estimation of the VECM shows that, in the long run equation, the coefficient associated with the variable is positive while in the short-run equation, the coefficients associated with the variables and are positive as expected but insignificant, which implies that a depreciation/appreciation of the U.S. dollar will have no effect on U.S. trade balance with India in the short run. We found no presence of J-curve effect in trade between the U.S. and India. Our finding also indicates that if the tariff results in an appreciation of the U.S. dollar, then it will not affect the U.S. trade balance with India in the short run and will only deteriorate trade balance in the long run.
J-curve effect, export-to-import ratio, exchange rate, unit root, cointegration