A new look at exchange rate volatility and trade flows

This study provides a comprehensive analysis of exchange rate volatility and trade. It examines exchange rate variability over the past 30 years for all countries for which data are available and employs state-of-the-art statistical techniques to test the natural presumption that volatility in exchange rates reduces the level of international trade. In terms of observed variability, the analysis here, shows that, while exchange rate fluctuations have increased in times of currency and balance of payments crises, there has been no clear increase in exchange rate volatility between the 1970s and the 1990s on average. It is not surprising that the currencies of the advanced economies have had lower average volatility than other country groups. Nonetheless, many transition, emerging market, and developing countries have recently exhibited exchange rate variability on a par-or close to - that of many advanced economies. In terms of the impact of exchange rate volatility on trade flows, the current study does not find a robust negative effect. To be more precise, the study reports some evidence that is consistent with a negative effect of volatility on trade; however, such a relationship is not robust to certain reasonable perturbation of the specification. Specifically, when time-varying, country-fixed effects are allowed-which are suggested by recent theoretical work on the gravity model specification-the analysis does not reveal a negative association between volatility and trade.