Investigating the Determinants of the Trade Balance: The Case of the UK

Abstract

This paper examines the drivers of the trade balance in the United Kingdom by applying the innovative dynamic ARDL model, which offers the advantage of simultaneously identifying both short- and long-run interconnectedness. The endogenous variable is the trade balance, while the exogenous variables are the home country's GDP (UK), the foreign country's GDP (USA), FDI inflows, the exchange rate, and government expenditure. The existence of a long-run relationship between trade balance and the independent variables is confirmed through the ARDL approach-based bounds and Bayer–Hanch cointegration tests. There is a significant impact in the long-run for all variables. Except for the home GDP and exchange rate variables, there is a positive contribution of foreign GDP, government expenditures, and FDI to the trade balance in the long run. However, the home GDP and exchange rate have a positive and significant impact on the trade balance in the short run. Based on the outcomes of our study, we can suggest that to finance its current (and capital) account deficit, it is essential to increase the foreign exchange reserves and make new investments in the UK. The government designs and implements policies in a way that attracts net financial inflows to the country while improving the terms of trade through foreign direct investment. However, export-oriented production would stimulate both the home GDP and foreign exchange reserves.

JEL: F10, F20, C32