Exchange rates, international trade and growth : re-evaluation of underevaluation

This paper shows that a regional bias resulting from trade integration alters the transmission of a countryś monetary policy by shifting the burden of the exchange rate adjustment towards the less integrated trading partners. I first develop a simple model which illustrates how a concentration of trade flows among regional trading partners affects the sensitivity of the trade balance to the terms-of-trade. In particular, the trade balance becomes less sensitive to the terms-of-trade vis-`avis regional partners and more sensitive to the terms-of-trade vis-`a-vis the other country. I then test the implication of the model using a panel of 133 countries between 1985 - 2010 that includes information on Regional Trade Agreements (RTA). I find that movements in the terms-of-trade vis-`a-vis non-RTA members affect a countryś trade balance, while movements vis-`a-vis RTA partners do not.