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International Monetary Fund | October 2015
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1
CHAPTER
International Monetary Fund | October 2015
105
3
CHAPTER
EXCHANGE RATES AND TRADE FLOWS: DISCONNEC TED?
Recent exchange rate movements have been unusually
large, triggering a debate regarding their likely effects on
trade. Historical experience in advanced and emerging
market and developing economies suggests that exchange
rate movements typically have sizable effects on export
and import volumes. A 10 percent real effective deprecia-
tion in an economy’s currency is associated with a rise in
real net exports of, on average, 1.5 percent of GDP, with
substantial cross-country variation around this average.
Although these effects fully materialize over a number
of years, much of the adjustment occurs in the first year.
The boost to exports associated with currency depreciation
is found to be largest in countries with initial economic
slack and with domestic financial systems that are operat-
ing normally. Some evidence suggests that the rise of
global value chains has weakened the relationship between
exchange rates and trade in intermediate products used as
inputs into other economies’ exports. However, the bulk
of global trade still consists of conventional trade, and
there is little evidence of a general trend toward disconnect
between exchange rates and total exports and imports.
Introduction
Recent exchange rate movements have been unusu-
ally large. 周 e U.S. dollar has appreciated by more
than 10 percent in real eff ective terms since mid-2014.
周 e euro has depreciated by more than 10 percent
since early 2014 and the yen by more than 30 per-
cent since mid-2012 (Figure 3.1).1 Such movements,
although not unprecedented, are well outside these
currencies’ normal fl uctuation ranges. Even for emerg-
ing market and developing economies, whose curren-
cies typically fl uctuate more than those of advanced
economies, the recent movements have been unusually
large.
周 e authors of this chapter are Daniel Leigh (team lead),
Weicheng Lian, Marcos Poplawski-Ribeiro, and Viktor Tsyrennikov,
with support from Olivia Ma, Rachel Szymanski, and Hong Yang.
1Based on consumer price index–based real eff ective exchange rate
data ending in June 2015.
–40
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–20
–10
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36
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–20
–10
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36
1. United States
(July 2014)
2. Japan
(August 2012)
3. Euro Area
(April 2014)
Current episode
25th/75th percentile
10th/90th percentile
4. Brazil
(August 2014)
5. China
(May 2014)
6. India
(February 2014)
Major currencies have seen large movements in recent years in real effective terms
that are unusual compared with historical experience.
Figure 3.1. Recent Exchange Rate Movements in Historical
Perspective
(Percent; months on x-axis)
Source: IMF, Information Notice System.
Note: Figure reports historical fluctuation bands for level of consumer price
index–based real effective exchange rate based on all 36-month-long evolutions
since January 1980. Confidence band at month t is based on all historical
evolutions up to month t. Blue lines indicate most recent exchange rate paths of
appreciation or depreciation that have no interruptions of more than three
months. Dates in parentheses mark the starting point for the current episode in
each panel. Last observation reported is June 2015.
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WORLD ECONOMIC OUTLOOK: ADJUSTING TO LOWER COMMODITY PRICES
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International Monetary Fund | October 2015
周ere is little consensus, however, on the likely
effects of these large exchange rate movements on
trade––exports and imports––and, therefore, on
economic activity. Some have predicted strong effects,
based on conventional economic models (Krug-
man2015, for example). Others have pointed to the
limited changes in trade balances in some economies
following recent exchange rate movements—in Japan,
in particular—implying an apparent disconnect
between exchange rates and trade. It has also been
suggested that the increasing participation of firms
in global value chains has reduced the relevance of
exchange rate movements for trade flows, as in recent
studies conducted at the Organisation for Economic
Co-operation and Development (Ollivaud, Rusticelli,
and Schwellnus2015) and the World Bank (Ahmed,
Appendino, and Ruta 2015).2
周is is not the first time that the conventional
wisdom regarding the link between exchange rates
and trade has been questioned. In the late 1980s, for
example, the U.S. dollar depreciated, and the yen
appreciated sharply after the 1985 Plaza Accord, but
trade volumes were slow to adjust, leading some com-
mentators to suggest a disconnect between exchange
rates and trade. By the early 1990s, however, U.S. and
Japanese trade balances had adjusted, after some lags,
largely in line with the predictions of conventional
models.3 A key question is whether this time is differ-
ent, reflecting the changing structure of world trade
since the 1990s, or whether, once lags have played out,
the apparent disconnect between exchange rates and
trade will once again dissipate.
A disconnect between exchange rates and trade
would have profound policy implications. It could, in
particular, weaken a key channel for the transmission
of monetary policy by reducing the boost to exports
that comes with exchange rate depreciation when mon-
etary policy eases. It could also complicate the resolu-
tion of trade imbalances (that is, when exports exceed
imports, or vice versa) via the adjustment of relative
trade prices.
To contribute to the debate on the likely effects of
recent currency movements and to assess whether trade
flows are becoming disconnected from exchange rates,
this chapter focuses on the following questions:
2As explained in the discussion that follows, during the past
several decades, international trade has increasingly been organized
within so-called global value chains, with different stages of produc-
tion located across different economies.
3See Krugman 1991 for a discussion of this episode.
• Based on historical experience, how does trade
typically evolve following real exchange rate move-
ments? In particular, to what extent do exchange
rate changes pass through to the relative prices of
exports and imports, and how strongly do trade
flows respond following these trade price changes?
How quickly do the adjustments occur?
• Is there evidence of a disconnect between exchange
rates and trade over time? In particular, has the
changing structure of global trade, with increas-
ing participation in global value chains, weakened
the relationship between exchange rates and trade?
Have either the long-term effects or the speed of
transmission of exchange rate movements declined
over time, making them less relevant for overall
trade?
To address these questions, the chapter starts by
investigating the relationship between exchange rate
changes and trade in advanced and emerging mar-
ket and developing economies over the past three
decades. 周e growing importance of emerging market
and developing economies in world trade warrants
this broad coverage, which goes beyond the group of
economies typically examined in related studies.4 周e
approach employs both standard trade equations and
an analysis of historical cases of large exchange rate
movements. 周e chapter then assesses whether the rise
of global value chains, also referred to as the inter-
national fragmentation of production, has weakened
the link between exchange rates and trade. Finally, it
investigates more generally whether there is evidence
of disconnect over time by estimating the relationship
between exchange rates and trade in different historical
periods.
周e analysis focuses narrowly on the direct effect
of exchange rate changes on trade. Although the trade
channel is a critical channel for the transmission of
exchange rate changes to an economy, this partial
equilibrium focus on direct effects has limitations. By
definition, it ignores the general equilibrium effects
of exchange rate changes on overall economic activ-
ity, which involve not just the effects on trade, but
also those operating through other variables, includ-
ing inflation expectations, interest rates, and domes-
4Much of the related literature focuses on advanced economies,
with a number of exceptions, including Bussière, Delle Chiaie, and
Peltonen 2014, which estimates trade price equations for 40 econo-
mies, and Morin and Schwellnus 2014.
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103
CHA PTER 3
EXCH ANG E RATES AND T RA DE FLO WS : D ISC ONNEC TED?
International Monetary Fund | October 2015
107
tic demand.5 周rough the effects on these variables,
trade is also affected indirectly. 周e narrow focus also
abstracts from the fact that the underlying drivers of
an exchange rate change also matter for trade and
economic activity outcomes. 周e main reason that
these outcomes can differ is that the indirect effects
of exchange rate changes can differ, depending on
the driver. Consider, for example, the exchange rate
changes during the past year or so. As discussed in the
April 2015 World Economic Outlook (WEO), these
changes have been partly driven by surprises in the
relative strength of domestic demand, with countries
with stronger domestic demand experiencing apprecia-
tion. Compare this with another example, in which
the exchange rate change is not driven by domestic
demand, but reflects an unexpected shift in investor
preferences for U.S.-dollar-denominated assets. 周e
behavior of domestic demand in the two examples
would clearly be different, with implications for the
overall outcome for trade.
周e chapter’s main findings are as follows:
• Trade tends to respond strongly to exchange rate
movements. A depreciation in an economy’s cur-
rency is typically associated with lower export prices
paid by foreigners and higher domestic import
prices, and these price changes, in turn, lead to a
rise in exports and a decline in imports.6 Reflecting
these channels, a 10 percent real effective exchange
rate depreciation implies, on average, a 1.5 percent
of GDP increase in real net exports. The figures
around this average response vary widely across
economies (from 0.5 percent to 3.1 percent). It
takes a number of years for the effects to fully
materialize, but much of the adjustment occurs in
the first year. The export increase associated with
currency depreciation is typically stronger when the
domestic economy is experiencing more slack, but
weaker when a country’s financial system is weak, as
in the context of a banking crisis.
• The rise of global value chains has weakened the
relationship between exchange rates and trade for
5For an example of a general equilibrium assessment of the effects
of exchange rate movements, see Scenario Box 2 in the April 2015
World Economic Outlook, which uses the IMF’s G20 Model to
explore the potential macroeconomic impact of real exchange rate
changes from August 2014 to February 2015 based on shocks that
represent changes in investor preferences for U.S.-dollar-denomi-
nated assets.
6周ere is little evidence of asymmetry—exchange rate apprecia-
tions and depreciations tend to have opposite effects, but of a similar
absolute size.
some economies and products, but little evidence
shows that it has led to a disconnect between
exchange rates and trade in general. In particular, for
economies that have become more deeply involved
in global value chains, trade in intermediate prod-
ucts used as inputs into other economies’ exports
has become less responsive to exchange rate changes.
However, the relative pace of expansion of global-
value-chain-related trade has decelerated in recent
years, and the bulk of global trade still consists of
conventional trade.
• More generally, the notion of a disconnect between
exchange rates, trade prices, and gross export and
import volumes finds little support in the data. The
estimated links have not generally weakened over
time. A key exception to this pattern is Japan, which
displays some evidence of disconnect, with weaker-
than-expected export growth despite substantial
exchange rate depreciation, although this weak
export growth reflects a number of Japan-specific
factors.7
From Exchange Rates to Trade:
Historical Evidence
A natural benchmark for assessing the implications
of recent exchange rate movements is the histori-
cal relationship between exchange rates and trade.
Standard theoretical models predict that currency
depreciation will reduce the prices of exports in foreign
currency and increase the prices of imports in domes-
tic currency, which will lead to more exports and
less imports.8 周ese theoretical predictions guide the
statistical analysis in this chapter.
周is section starts by examining the historical evi-
dence on the connection between exchange rates, trade
prices, and trade volumes for a large group of econo-
mies. It estimates export and import price and volume
equations for 60 individual economies––23 advanced
and 37 emerging market and developing economies––
for the past three decades. 周is is a broader sample of
economies than is typically covered in related studies.9
7周ese factors include, in particular, the acceleration in production
offshoring since the global financial crisis and the 2011 earthquake.
8周e response of trade volumes to relative trade prices relates to
the expenditure-switching effect discussed, for example, in Obstfeld
and Rogoff 2007.
9Related studies also tend to focus on either the effect of exchange
rates on relative trade prices or the effect of relative trade prices on
volumes. In contrast, the analysis here focuses on both parts of the
137
WORLD ECONOMIC OUTLOOK: ADJUSTING TO LOWER COMMODITY PRICES
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International Monetary Fund | October 2015
To contribute more directly to the debate on the
recent large exchange rate changes, the section also
presents evidence on trade dynamics following unusu-
ally large exchange rate movements. 周e focus is on the
evolution of export prices and volumes following large
and sudden currency depreciations in both advanced
and emerging market and developing economies.
Revisiting Trade Elasticities
To inform the assessment of the likely impact of the
recent large exchange rate movements on trade, this
subsection estimates standard trade elasticities (that is,
how responsive trade variables are to changes in other
variables) for both advanced and emerging market
and developing economies. In particular, it focuses on
estimating four elasticities: the relationship between
exchange rate movements and export and import
prices, respectively (exchange rate pass-through), and
the relationship between these export and import
prices and trade volumes (price elasticity), based on
standard trade equations. 周e emphasis is on long-
term effects of exchange rate movements, although the
discussion also touches on how much of these long-
term effects materialize in the near term.
周e theoretical framework underlying the analy-
sis comes from the pricing-to-market literature, as
described in Krugman 1986, Feenstra, Gagnon, and
Knetter 1996, Campa and Goldberg 2005, Burstein
and Gopinath 2014, and others. In this framework,
exporting firms maximize profits by choosing export
prices subject to the demand for their products in
foreign markets, taking into account their competi-
tors’ prices.10 Product demand depends on the prices
of exports relative to the prices of competing products
as well as on overall demand conditions in destination
markets. Based on these assumptions, export prices
relative to foreign prices depend on the real exchange
rate and real production costs, while export quantities
depend on these relative export prices as well as on
foreign aggregate demand. 周e determinants of import
prices and quantities can be derived analogously based
on the observation that the price of each economy’s
exchange rate transmission process, thus providing a more compre-
hensive assessment.
10周is literature assumes market segmentation between domestic
and foreign purchasers.
imports is the price of its trading partners’ exports
multiplied by the bilateral exchange rate.11
周e analysis estimates the four trade elasticities at
the individual-economy level using annual data for
60 economies. Depending on data availability and
the economy in question, the sample starts between
1980 and 1989 and ends in 2014. To permit the
long-term relationship between exchange rate changes
and trade to be estimated, the sample is restricted to
economies for which at least 25 years of annual data
are available.12 周e analysis focuses on gross exports
and imports, which include both goods and services
(Annex 3.1 reports the sources of the data used). 周e
econometric specifications employed are standard and
yield estimates of the relationship between exchange
rates and trade prices and between trade prices and
trade volumes.13
11In this framework, the export price equation reflects opti-
mal pricing decisions of suppliers and can be written as ePX/P* =
S(ULC/P, eP/P*), in which e is the nominal exchange rate, PX is the
price of exports in domestic currency, P* is the foreign price level,
P is the domestic price level, ULC/P denotes the real unit labor
cost, and eP/P* denotes the real effective exchange rate. 周e export
volume equation represents the demand side of the market and can
be written as X = D(ePX/P*, Y*), in which ePX/P* is the relative
export price in foreign currency already mentioned and Y* denotes
foreign aggregate demand. On the import side, the relative prices of
imports are a function of the real exchange rate and domestic aggre-
gate demand, PM/P = S(eP*/P, Y ), in which Y denotes domestic
aggregate demand, and import volumes are a function of this relative
price and domestic aggregate demand, M = D(PM/P, Y ).
12周e sample excludes a number of advanced economies with
special circumstances, including Hong Kong SAR and Singapore,
given these economies’ significant entrepôt activity, and Ireland,
given its special treatment of export sales (April 2015 WEO). To
avoid unduly influencing the estimation results with developments
in small or very low-income economies, it also excludes economies
with fewer than 1 million inhabitants as of 2010 or with an average
per capita income (at purchasing-power parity) of less than $3,000
in 2014 prices.
13周e analysis is based on log-linear specifications for the four
trade equations. For each equation, the analysis checks whether the
variables included are cointegrated based on a Dickey-Fuller test, in
which case the equations are estimated in levels. For example, for
export prices, the specification estimated in levels for each economy
is
ePX
eP
ULC
ln
—–
t
= a + b ln
—
t
+ g ln
——
t
+ e
t
,
P*
P*
P
ePX
in which the subscript t denotes the tth year;
—–
denotes the rela-
P*
tive price of exports in foreign currency (e is the nominal effective
exchange rate; PX is the price of exports in domestic currency; and
P* is the foreign, trade-weighted producer price index [PPI]); and
eP
—–
is the PPI-based real effective exchange rate. 周e PPI repre-
P*
sents the relative price of goods and services produced at home and
abroad more precisely than does the consumer price index (CPI).
Nevertheless, as reported later, the results are similar when all the
119
CHA PTER 3
EXCH ANG E RATES AND T RA DE FLO WS : D ISC ONNEC TED?
International Monetary Fund | October 2015
109
A number of issues complicate the estimation of
trade elasticities and can bias the analysis against find-
ing any effect of exchange rate movements on trade.
Different economic developments can lead to differ-
ent joint evolutions of trade prices and quantities,
complicating the estimation of the causal effects of
trade prices on quantities. 周e main potential source
of this simultaneity problem is the movement in either
domestic or foreign demand. For example, a contrac-
tion in foreign demand can cause a simultaneous
decline in both the quantity and the price of exports,
obscuring the conventional positive effect of a drop in
export prices on export demand. And when domestic
demand growth is weak, reducing imports, the price of
imports may also fall, obscuring the positive effect of
lower import prices on imports. 周e analysis addresses
this source of endogeneity by controlling for foreign
and domestic output.14 周is leaves shifts in the compo-
sition of demand or in the propensity to import for a
given composition of demand. 周e analysis attempts to
control for shifts in composition by including nonex-
ports and exports together in the import equation, but
controlling for shifts in import propensities is chal-
lenging. Overall, because of these remaining sources of
bias, weak or perversely signed estimation results could
still arise, although they do not necessarily imply that
trade is unresponsive to changes in trade prices.15
P and P* terms in the equation are replaced with the domestic and
foreign CPI. 周e estimate for b provides the long-term effect of the
exchange rate on export prices. Short-term effects are obtained by
estimating, in a second step, the equation in error correction form,
as explained in Annex 3.2. 周e equations for estimating the other
elasticities are set up analogously, as also explained in Annex 3.2.
14Moreover, all equations also include a time trend to account for
secular trends in the variables and a dummy variable (which equals
1 during 2008–09) to account for the global financial crisis and
the interaction of this crisis dummy with the measure of foreign
output in the export volume equation and with the measure of
domestic output in the import volume equation, respectively. 周ese
interaction terms address the notion that trade responded unusually
strongly to demand during the crisis (see, for example, Bussière and
others 2013). In addition, to control for shifts in global commod-
ity prices, which can affect exporting firms’ costs, the equations for
export and import prices control for the (log) indices of interna-
tional fuel and nonfuel commodity prices. To ensure the results are
not driven by periods of high inflation (such episodes can be caused
by factors that have an independent effect on trade), the sample
excludes years in which CPI inflation exceeds 30 percent. As a
further precaution against outliers, observations with Cook’s distance
greater than 4/N, where N is the sample size, are discarded.
15A large literature that goes back to Orcutt (1950) explains how
simultaneity and omitted-variable issues can lead to considerable
underestimation of trade price elasticities. Another issue that biases
the analysis against finding a strong effect of trade price changes
on trade is that of heterogeneous elasticities across different goods.
Results: From Exchange Rates to Trade Prices
周e analysis suggests that exchange rate movements
typically have substantial effects on trade prices, with
the estimates of long-term pass-through elasticities
having the expected sign for virtually all the economies
considered (Figure 3.2). 周e estimates of exchange rate
pass-through typically lie, as would be expected, in the
0–1 interval. 周e results imply that, on average, a 10
percent real effective currency depreciation increases
import prices by 6.1 percent and reduces export prices
Different goods have different price elasticities, but movements in
aggregate trade prices may be dominated by movements in the rela-
tive prices of price-inelastic goods. 周is dominance would dampen
estimated price effects on trade flows. In fact, micro-level estimates
of trade elasticities tend to be somewhat larger than those based on
aggregate data, as discussed by Feenstra and others (2014) and Imbs
and Mejean (2015).
–0.5
0.0
0.5
1.0
1.5
–1.5
–1.0
–0.5
0.0
Exchange rate pass-through to
export prices
Exchange rate pass-through to import prices
–2.5
–2.0
–1.5
–1.0
–0.5
0.0
0.5
1.0
1.5
2.0
–1.5
–1.0
–0.5
0.0
0.5
1.0
1.5
Price elasticity of export volumes
Price elasticity of import volumes
1. Exchange Rate Pass-Through
2. Price Elasticities
Individual-economy estimates
Average
The estimated effects of exchange rate movements on trade prices and volumes
have the expected sign for most of the economies considered.
Figure 3.2. Long-Term Exchange Rate Pass-Through and Price
Elasticities
Source: IMF staff estimates.
Note: Estimates based on annual data for 60 advanced and emerging market and
developing economies from 1980 to 2014. Boxes indicate the expected sign and,
in the case of exchange rate pass-through, the expected size of the estimates.
117
WORLD ECONOMIC OUTLOOK: ADJUSTING TO LOWER COMMODITY PRICES
110
International Monetary Fund | October 2015
in foreign currency by 5.5 percent (Table 3.1).16 周e
estimation results are broadly in line with existing
studies for major economies.17 It is interesting to note
that economies with stronger exchange rate pass-
through to export prices in foreign currency tend to
have weaker pass-through to domestic import prices, a
pattern that also emerges from the findings of Bussière,
Delle Chiaie, and Peltonen (2014). 周e results also
indicate that most of the long-term effects on trade
prices materialize within one year.18
16周e corresponding response of export prices in domestic currency
to a real effective currency depreciation of 10 percent would be a rise
of 4.5 percent (–10 × (0.552 – 1)).
17For example, the results are strongly correlated with those
reported in a recent study by Bussière, Delle Chiaie, and Peltonen
(2014), who report pass-through elasticities for 40 economies
(Annex Figure 3.2.1).
18周e estimates of pass-through to trade prices also have implica-
tions for the estimated effect of a change in the exchange rate on
the terms of trade (the price of exports relative to imports), which
have implications for domestic demand. 周e baseline long-term
pass-through estimates reported in Table 3.1 are 0.55 for export
prices in foreign currency and −0.61 for import prices in domestic
currency. So a 1 percent appreciation in a country’s currency lowers
the domestic prices of its imports by 0.61 percent and raises the
foreign-currency price of exports by 0.55 percent. 周is means that
the domestic-currency price of exports falls by 0.45 percent (0.55 −
1) and the terms of trade improve by 0.16 percent (−0.45 − (−0.61))
following a 1 percent appreciation. 周is is well below the full pass-
through case in which a 1 percent appreciation translates into a 1
percent improvement in the terms of trade.
Results: From Trade Prices to Trade Volumes
周e analysis suggests that trade price movements
typically have the expected effects on export and import
volumes, with most individual-economy estimates hav-
ing the conventional (negative) sign (Figure 3.2, panel
2). On average, the estimated price elasticities of vol-
umes suggest that a 10 percent rise in export and import
prices reduces the level of both export and import
volumes by about 3 percent in the long term (Table
3.1). 周e results also indicate that most of the long-term
effects on trade volumes materialize within one year.
At the same time, numerous individual-economy
estimates have counterintuitive (positive) signs. Given
the challenges already mentioned of identifying the
effects of trade prices on volumes, these exceptions
are not surprising, and the true effects are likely to be
stronger than suggested by the cross-country aver-
ages reported in Table 3.1. Also, the sample includes a
range of economies, including some for whom fuel and
nonfuel primary products constitute the main source
of export earnings (exceeding 50 percent of total
exports). To investigate whether these primary-product
exporters have a strong influence on the estimation
results, the analysis is repeated while excluding them
from the sample. 周e results are similar to the baseline,
suggesting that these economies are not driving the
results (Table 3.1).
Meanwhile, the effects of shifts in foreign and
domestic aggregate demand on export and import vol-
umes have the expected positive sign for all economies
Table 3.1. Exchange Rate Pass-Through and Price Elasticities
Exchange Rate Pass-Through
Price Elasticity of Volumes
Marshall-Lerner
Condition Satisfied?1
Export Prices
Import Prices
Exports
Imports
Based on Producer Price Index2
Long-Term
0.552
–0.605
–0.321
–0.298
Yes
One-Year Effect
0.625
–0.580
–0.260
–0.258
Yes
Based on Consumer Price Index3
Long-Term
0.457
–0.608
–0.328
–0.333
Yes
One-Year Effect
0.599
–0.546
–0.200
–0.200
Yes
Memorandum
Noncommodity Exporters4
Long-Term Elasticity2
0.571
–0.582
–0.461
–0.272
Yes
Source: IMF staff estimates.
Note: Table reports simple average of individual-economy estimates for 60 economies during 1980–2014.
1The formula for the Marshall-Lerner condition adjusted for imperfect pass-through is (–ERPT of P X)(1 + price elasticity of X) + (ERPT of P M)(1 + price elastic-
ity of M) + 1 > 0, in which X denotes exports, M denotes imports, and PX and PM denote the prices of exports and imports, respectively (Annex 3.3).
2Estimates based on producer price index–based real effective exchange rate and export and import prices relative to foreign and domestic producer prices,
respectively.
3Estimates based on consumer price index–based real effective exchange rate and export and import prices relative to foreign and domestic consumer prices,
respectively.
4Excludes economies for which primary products constitute the main source of export earnings, exceeding 50 percent of total exports, on average, between
2009 and 2013.
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