The Effect of Exchange Rate on Iranian Trade Balance under Uncertainty

The main objective of this study is to investigate the non-linear impacts of macroeconomic instability on the relationship between exchange rate and trade balance of Iran. For this purpose, using annual time series over the period 1973 to 2017, computing the combined index of economic instability using variables such as consumer price index, foreign reserves, exchange rate, budget deficit and long run deposits rates. After that the effect on the relationship between exchange rate and trade balance has been estimated applying Markov-Switching technique. The results indicate that Iranian macroeconomic instability is dividable into two regimes including high macroeconomic instability (regime 1) and low macroeconomic instability (regime 2). Increased exchange rate has induced the improvement of trade balance in both regimes. The effect of macroeconomic instability on exchange rate – trade balance relation, is negative and significant in two regimes. In two regimes macroeconomic instability deteriorates the effect of exchange rate on trade balance.