Modelling Trade Sector and Trade Shocks in a Small Open Economy

Abstract

The article examines the impact of external trade shocks on the economy of Sri Lanka, a small and open developing economy with high external trade intensity. Given a variety of specifications, we favour estimating both export demand and supply functions and an import demand function. Export demand depends on own price, world export prices and world income whereas export supply depends on own price, input prices and production capacity. Import demand is dependent on income and the relative price. Combining the trade sector with the rest of the economy, the article performs simulation experiments on external trade shocks. Results reveal that an increase in import prices has a significant impact on nominal variables and improves the current account of the balance of payments. An increase in world income has a highly persistent positive impact on the current account. Further, as these trade shocks affect the nominal sector of the economy greatly, measures should be taken to cushion any associated destabilizing impact on the economy. The results also imply that export sector businesses should have the flexibility to vary the production capacity in the face of such shocks.