Journal of Finance and Economics, 2014, Vol. 2, No. 3, 83-89 Available online at http://pubs.sciepub.com/jfe/2/3/5 © Science and Education Publishing DOI:10.12691/jfe-2-3-5 Relationship between Currency Depreciation and Trade Balance in India- An Econometric Study Kanchan Datta * Associate Professor of Economics, University of North Bengal *Corresponding author: kanchan.datta@gmail.com Received March 02, 2014; Revised March 11, 2014; Accepted March 16, 2014 Abstract The effective exchange rate is a measure of whether or not the currency is appreciating or depreciating against a basket of foreign currencies. In this paper an attempt has been taken to enquire the relationship between exchange rate and trade balance in India, here we use we use 36 currency trade based effective exchange rate both nominal and real. A decline in the value of effective exchange rate implies a depreciation of the home currency against the basket of currencies. The data are taken from statistical hand book of India published by RBI. The variables in this study are Trade Balance, Nominal Effective Exchange Rate, Real Effective Exchange Rate. Trade balance is measured by taking the ratio of import and export then converted in to logarithmic form, so trade balance implies log import – log export. This study shows that increase of trade balance of our country is one of the important reasons for depreciating our currency. Since trade balance is the ratio of import and export hence increase in trade balance implies more of import and or less of export is one of the important reasons for depreciation of our currency over the time period of the study. Keywords: effective exchange rate, trade balance, India, Vector Error Correction model Cite This Article: Kanchan Datta, “Relationship between Currency Depreciation and Trade Balance in India- An Econometric Study.” Journal of Finance and Economics, vol. 2, no. 3 (2014): 83-89. doi: 10.12691/jfe-2-3-5. 1. Introduction The exchange rate that prevails at a given date is known as the nominal exchange rate. It is amount of one currency interms of one unit of another currency. Since most of the countries of the world do not conduct all their trade with a single foreign country, policy makers are not so much concerned with what is happening to their exchange rate against a single foreign currency but rather what is happening to it against a basket of foreign currencies with which the country trades. The effective exchange rate is a measure of whether or not the currency is appreciating or depreciating against a basket of foreign currencies. While effective exchange rate provides a reasonable measure of changes in a countries competitive position for periods of several months, it does not take into account of the effect of price movements. In order to get a better idea of changes in countries competitive we would need to compile a real effective exchange rate index. In this paper we use 36 currency trades based effective exchange rate both nominal and real. A decline in the value of effective exchange rate implies a depreciation of the home currency against the basket of currencies. In this paper an attempt has been taken to enquire the relationship between exchange rate and trade balance in India. The data are taken from statistical hand book of India published by RBI and they are monthly in nature. The variables in this study are Trade Balance (TBal), Nominal Effective Exchange Rate (NEER), Real Effective Exchange Rate (REER). Trade balnce is measured by taking the ratio of import and export then converted in to logarithmic form, so trade balance implies log import – log export. An increase of this difference implies more of import or less of export or both which actually reflects a deterioration of trade balance, on the other hand a decline of this log difference implies either increase in export or decrease in import or both which actually reflects an improvement of trade balance. All the other variables are also converted into logarithmic form. The time period covers from April 2009 to September 2013. Augmented Dickey Fuller, Phillips- Perron Unit root test, Johansen Co integration technique, Vector Error Correction model, Granger Causality etc. technique are used in this study. 2. Methodology In econometric analysis, when time series data are used, the preliminary statistical step is to test the stationarity of each individual series. Unit root tests provide information about stationarity of the data. Nonstationarity data would contain unit roots. The main objectives of unit root tests is to determine the degree of integration of each individual time series.Results derived from the regression models would produce’Spurious Results’ if we use the data without checking their Stationarity Properties. We can examine the stationarity of the datasets through following methods. 2.1. Augmented Dickey-Fuller Unit Root Test