Page 4 - Azerbaijan State University of Economics

THE JOURNAL OF ECONOMIC SCIENCES: THEORY AND PRACTICE, V.72, # 2, 2015, pp. 4-23

FACTOR-AUGMENTED J-CURVE

Mahammad R. Jamilov
Ph.D., Azerbaijan State University of Economics (UNEC)

Rustam M. Jamilov
Ph.D., London Business School. Corresponding author. We are grateful to Mohsen
Bahmani-Oskooee for providing the trade balance data. Opinion presented in this
paper belongs solely to the authors and does not necessarily reflect the viewpoints of
UNEC or LBS

Received 16 July 2015; accepted 16 December 2015; published online 29 December 2015

Abstract
We introduce the notion of the factor-augmented J-curve which substantially
improves the presentation of and the intuition behind industrial J-curve analysis.
Explorative factor analysis is performed on a large number of bilateral industry-level
trade balances, and a small number of common factors is extracted. An Auto-
Regressive Distributed (ARDL) model is then estimated for the bilateral exchange
rate and the scores of the extracted factors. The new strategy is tested on a dataset of
US-China bilateral trade over the 1981-2006 period. Factor analysis reduces the
parameter dimension from 59 industries to 9 composite factors, to which we
arbitrarily assign intuitive labels. Estimation of the trade balance model via ARDL
reveals that for 3 factors, namely Total Trade, Heavy Metals and Organic Chemical
Industries, and Agriculture and Non-Organic Chemical Industries, the trade balance
improves in the long run following a depreciation in the exchange rate. Evidence for
the presence of the J-curve effect in the short run is also found. According to the
CUSUM and CUSUMSQ tests for parameter stability our results are stable and
policy implications are robust. This analysis carries policy implications and is
replicable for any bilateral trade dataset.

Keywords: J-curve; Marshall-Lerner Condition; Factor Analysis; ARDL Regression
JEL Codes: C38, F14, F31
Introduction
The methodological journey of the J-curve stream of literature has been long and
extensive. The nexus between trade balance performance and exchange rate

4