An Analysis of Singapore's Trade Balance and Real Exchange Rate in Response to Shocks

Understanding the behaviour of the real exchange rate and trade balance is a central problem in open economy macroeconomics. The development of an intertemporal optimising open economy model since the early eighties is an important advance over previous work that lacked strong microfoundations. Despite this, there has been relatively little research that empirically tests how well the intertemporal optimising open economy model performs in explaining the response of the real exchange rate and trade balance to shocks of different nature. Vegh (2013) notes that “real exchange rate and trade balance are simply an equilibrium response to shocks, with no causality whatsoever” in the intertemporal optimizing model. A small open economy like Singapore with high trade openness is sensitive to changes in the global economic environment, which can be regarded as exogenous. The economy faced shocks of different nature such as the Severe Acute Respiratory Syndrome epidemic in 2003 and the Global Financial Crisis in 2008/09. The paper models these exogenous shocks and compares the theoretical predictions on the response of trade balance and real exchange rate to Singapore’s data. The predictions generally fit well to the data. It is shown that a real appreciation does not always go hand-in-hand with a trade deficit in the event of a negative productivity shock. In a lesser-known trend, Singapore’s terms of trade have experienced a long-term decline since the 1980s. However, during the same period, the trade balance has grown steadily to almost 30% of the GDP in 2019. The paper seeks to uncover the reasons for the terms of trade decline and the implications for the trade balance and real exchange rate.