The Effect of Exchange Rate Fluctuation on Trade Balance: Empirical Evidence from Saudi Arab Economy

Fluctuation of the exchange rate has a different unwanted implication towards the economic growth. The right choice of exchange rate regime will bring an economy back to the equilibrium and many economists claim that it is one of the factors for the positive economic development. In contrast, a long term fluctuation of the real exchange rate from the nominal rate can lead to severe macroeconomic imbalances, lead to speculation attack and against the orthodoxy of macroeconomic parities. However the empirical findings of previous studies with regards to the relationship of exchange rate and trade balance are not inclusive and are inconsistent for different countries. The main objective of this paper is to analyse the long run relationship between fluctuation of exchange rate and trade balance in Saudi Arab. The economy of the Saudi Arab has developed tremendously in which the average gross domestic production (GDP) for the period of 1980 – 2008 is more than 300 percentages. Using the Purchasing Power Parity (PPP) model, we empirically identify that the currency of Saudi Arabia at most of the time are overvalued. The study also shows Saudi Arab is enjoying positive trade balance. Utilising two-step Engel-Granger co-integration technique we find a significant long run relationship between the exchange rate fluctuation and trade balance for Saudi Arab in the long run but not in the short-run.