The relationship between real effective exchange rate and terms of trade: The analysis of Turkey

Abstract

The improvement in the terms of trade, while the other conditions are constant, allows for higher imports in exchange for export provisions. An external shock to terms of trade can also affect the exchange rates in a relatively small country. The improvement in the terms of trade increases export prices. Under the assumption that the pass-through effect of the exchange rate changes on prices is high and that goods subject to foreign trade are elastic, depreciation or appreciation of the national currency is expected to affect the terms of trade by setting the relative export price. This study investigate the existence of co-integration and causality relationship between the real effective exchange rate and terms of trade in Turkey for the period 2010-2017. The results demonstrated the existence of a long-term co-integration relationship between terms of trade and real effective exchange rate. The Granger causality test results showed that there was a two-way causality between these two variables. In other words, it was found that both the changes in the real effective foreign exchange rates affect the external terms of trade and the changes in the external terms of trade affect the real effective foreign exchange rate.