Testing the Validity of the J-Curve Hypothesis Between China and the United States

Abstract

This paper investigates the efficacy of currency management as a policy tool to improve trade balance by analyzing the impact of the real exchange rate on the bilateral trade between the United States and China. The paper builds upon the existing literature and empirical analysis is carried out based on the J-curve hypothesis using quarterly data from 2000Q1 to 2021Q4. The vector-auto regression (VAR) model is estimated using China and the United States’ trade balance, real exchange rate, and GDP. The impulse response functions provide evidence of the J-curve. A shock in Yuan (CNY)-US dollar real exchange rate leads to initial deterioration but improvement in the trade balance in favor of China over subsequent quarters. The results hold for various sub-periods of analysis, i.e., after the exchange rate was allowed to fluctuate since July 2005. Evidence supports that the policy of managing the real exchange rate might have yielded desired results for China.