Empirical Study of the Correlation Between Trade Balance and Its Determinants

Global International Economics

Empirical Study of the Correlation between Trade Balance and its Determinants

Prepared by:

IBM Petra Christian University

Surabaya - Indonesia

Rony Kristianto – 34405005

Andrean Chris Taneka – 34405037

Tan Hendri Tejo Martono – 34405041

Heradi Taruatmaja Dirautama – 34405048

Daniel Azwin Hanafi – 34405050

International Business Program

Faculty of Economics

Petra Christian University

1. Background

In this increasingly borderless world, a country’s economic activities occur not only inside that country but also outside. Therefore, the international economics subject is established. Among many topics that international economics cover, trade balance is one of the vital aspects in studying international economic activities. Trade balance is a part of a country’s Balance of Payments. It refers to the balance of exports value subtracted by imports value in a country in a period of time. The trade balance of a country is theoretically determined by five factors which are inflation rates, exchange rates, trade policies, domestic country’s income and foreign country’s income. Further explanation about terms and theoretical relationships of those factors with trade balance will be exposed in the next chapter.

Our research objective in this paper is to test the correlation between trade balance and its determinants in Indonesia and Japan (as the trading partner) during the periods of 2003-2007. We specifically choose Japan as the trading partner in this research, as opposed to the rest of the world, because two of our independent variables (namely exchange rates and foreign country’s income) will be much more complicated if multilateral trading activities are chosen instead of bilateral ones. The reason is because in multilateral trading activities, we need to sum up all the exports and imports values to and from other countries as well as to calculate the average value of exchange rates and foreign countries’ income. Furthermore, Japan is Indonesia’s most dominant trading partner. Our data from http://www.depperin.go.id shows that Japan is the biggest importer (non-migas) of Indonesia’s product in the period of 2003-2007 while it is also the biggest source of import (non-migas) for Indonesia in the period of 2003-2005. Therefore, the big values of trade between Indonesia and Japan will likely to depict valid correlation between trade balance and its determinants.

Due to the large variety of trade policies that a country’s government can impose, it will be very inconvenient to have trade policies as one of our independent variables in this research of correlation. The inconvenience comes from the impossibility to quantify all the comprehensive trade policies (tariffs, quotas, voluntary export restraints, local content requirements, etc.) that a government imposes in a single figure in a period of time. By this consideration, we will not include trade policies in our analysis and choose to have four independent variables, instead of five.

If the theory perfectly applies, we can expect a very strong correlation and very few errors between trade balance and its four determinants which are inflation rates, exchange rates, domestic country’s income and foreign country’s income (please note that trade policies factor is no longer listed due to the reason above). However, we also realize that, in the real world, those four factors alone do not determine trade balance. Trade balance is also influenced by the political relationship between a country and another, other international agreements, etc. Here in this paper, we intend to seek how much the theory explains the real conditions by using statistical measures.

By understanding whether the four determinants significantly influence trade balance and which of those determinants is the most significant, we will be able to present to several parties that may be concerned this empirical study as a reference for several parties in dealing with trade balance issues. First of all, the government can use this empirical study as a consideration in making exchange rates policies and fiscal policies which will give impact toward people’s disposable incomes such as taxation, subsidy and government spending. The government will get an insight