Taiwan is renowned for its economic development over the past five decades, from the early stages, when external aid was needed to various phases involving import substitution and export expansion, which led to industrialization.
While Taiwan’s exchange-market systems changed from fixed exchange rates to flexible ones in July 1978, the exchange rate did not fluctuate significantly. Not until the government decided to deregulate foreign-exchange controls in 1987, did the exchange rate change significantly.
According to development theories and empirical studies, export-expansion and import-substitution policies affected external-trade-sector growth and expansion, and also stimulated nominal exchange rates. This is known as the Balassa-Samuelson hypothesis.
The Balassa-Samuelson hypothesis (B-S Hypothesis) mainly focuses on the inference that rapid economic growth is accompanied by appreciation of the exchange rate. There are, however, some exceptions. For instance, as an economy moves from closed to open, to prevent huge trade deficits from occurring, the government may intentionally allow a nation’s currency to depreciate.
In the early stages of economic development, surplus labor shifts from agriculture to industry-trade sectors and services–non-trade sectors, offsetting wage pressures through increased productivity and relative price gaps between trade and nontrade sectors. In these situations, rapid economic growth may not cause the exchange rate to appreciate significantly.
In order to investigate and verify the long-term relationships between economic growth and exchange rate in Taiwan, we applied the bound-test approach referred to Pesaran, Shin and Smith (2001). By means of the unrestricted-error-correction model, we observed and compared whether different stages of economic development obtained different empirical results. Would, for example, strong economic growth cause exchange rates to appreciate, or might a currency be undervalued for a long period of time to stimulate economic expansion?
Another question is whether connections between economic growth and exchange rate can be proven by means of empirical methodologies? That is, does long-term equilibrium exist between economic growth and exchange rate? Will different conclusions happen at different stages of development?
The main advantages of the bound-test approach are that such an approach relaxes restrictions regarding integrated orders of time series. All time series used in empirical study may have different integrated orders. They could be first degree all together, or second degree or mixed. All of these situations are suitable for empirical applications. Persecutions can be solved when time series are integrated in different orders, though they cannot be applied in some methodologies such as co-integration analysis or error-correction models among others. In addition, they are also suitable for estimating small samples without causing bias or inefficiencies.
According to our empirical results, the B-S hypothesis attains different empirical results at different stages of development. The impact of economic growth on exchange rate changed significantly in 1987 as Taiwan gradually opened up and became more strongly interconnected with the global economy. The influences of real exchange rate on economic growth also achieve different inferences.
Applying relative per capita GDP (Taiwan against the United States) as the proxy for economic growth reveals a connection in only 1987 and thereafter. But exercising growth rate of relative per capita GDP (Taiwan against the United States) as the proxy for economic growth finds that real exchange rate has affected economic growth significantly since 1963. The real exchange rate apparently, therefore, contributes to economic growth.
Since the exchange rate is a concept involving relative price that may be concerned with global economic factors, many factors may affect prices such as institutional, political, economic and social. Determinants about exchange rate are very complicated, and the relationship between economic growth and real exchange rate is not so direct. Furthermore, exchange rate is not as similar as export or investment would be as components in GDP, so it is not easy to obtain empirical support to link exchange rate and economic growth. Nevertheless as national economies become increasingly interconnected with the global economy, exchange rate affects economic growth more significantly. Finally, economic cycles also affect exchange-rate fluctuations－stronger economic performance puts greater pressure on currencies to appreciate.
