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Impact of Financial Development on Trade Balance: An ARDL Cointegration and Causality Approach for Pakistan.

Ahad, Muhammad (2015): Impact of Financial Development on Trade Balance: An ARDL Cointegration and Causality Approach for Pakistan. Forthcoming in: Global Business Review , Vol. 19, No. 1 (2018)

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Abstract

This paper aim to examine the relationship between financial development, trade balance, exchange rate and inflation by using time series data from 1972 to 2014 for Pakistan. We have tested the unit root properties of variables by using Augmented Dickey-Fuller, Phillips-Perron and Breakpoint unit root tests. The ARDL approach is applied to examine the cointegration between variables due to mixed orders of integration between series I(0)/I(1). The ARDL findings suggested that long run relationship exists between financial development, trade balance, exchange rate and inflation. Error Correction Mechanism (ECM) is applied to analyze short run relationship. The lagged value of the Error Correction Term (ECMt-1) is negative and significant at 1% level of significance. The value of ECMt-1 is -0.91 which states that digression from the short run towards long run is corrected by almost 91 percent by every year. Financial development, exchange rate and inflation have significant impact on trade balance in the long run. But in the short run, only exchange rate and inflation have statistically significant impact on trade balance. Diagnostic statistics have confirmed the characteristics of model in the short run as well as in the long run. The causal relationship between variables are examined by VECM Granger causality and robustness of causal analysis is tested by Variance Decomposition Approach (VDA). The results of VECM have predicted that unidirectional causality from financial development to trade balance exist in the long run. The results of Variance Decomposition Approach explained that 19 percent of trade balance is explained by shocks stimulating in financial development. Government should enhance financial development by managing lending interest rates to improve trade balance.

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