0115 966 7955 Today's Opening Times 10:00 - 20:00 (GMT)
Place an Order
Instant price

Struggling with your work?

Get it right the first time & learn smarter today

Place an Order
Banner ad for Viper plagiarism checker

Impact of Exchange Rate Volatility on Bilateral Trade Flows

Disclaimer: This work has been submitted by a student. This is not an example of the work written by our professional academic writers. You can view samples of our professional work here.

Any opinions, findings, conclusions or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of UK Essays.

Published: Tue, 13 Feb 2018

Chapter 1: Introduction

The relationship between exchange rate volatility and trade flows has been extensively reviewed in literature. Exchange rate volatility refers to the extent to which prices of currencies tend to fluctuate over time. Theoretical literature has provided diverging views on the effect on exchange rate volatility on trade flows. Some authors argue that an increase in exchange rate volatility implies that risk averse firms are faced with uncertainty with respect to their earnings and hence would generally respond by redirecting their activity to local markets. On the other hand, other researchers pointed out that when the assumption of risk aversion is lifted, it can be argued that market participants are more likely to take advantage of the fluctuations in the exchange rate so as to increase their profits which will cause an increase in international trade.

The various empirical studies carried out on this topic have not been able to establish a clear link between exchange rate volatility and trade. Therefore from both theoretical and empirical point of view, the relationship between exchange rate and volatility is ambiguous.

Mauritius is often cited as an example of a country which has undergone successful trade liberalization and export-led growth. It is also said that trade policies has shaped the country’s path of industrial development, contributing to over two decades of steady growth and propelling the country in the ranks of the “newly industrialized economies”. However since the 1960s, the Mauritius has experienced much changes and reforms in its trade policy. Early trade policies adopted by Mauritius involved an import substitution strategy while at the same time providing incentives for export promotion. However as from the 1980s, Mauritius moved towards a more outward-oriented strategy and embarked on trade liberalisation. Imports restrictions and tariffs were reduced while economic stability was maintained. By the mid-1990s, Mauritius had one of the most liberal economic regimes in Africa. Incentives for export promotion like tax incentives, preferential rates of borrowing and so on were maintained. One of the key factors of exports competitiveness is the level of exchange rate in Mauritius which had to be kept low.

In addition the exchange rate regime itself in Mauritius has been deregulated over the years in a set of financial liberalisation measures. The exchange rate regime in Mauritius has also evolved from a fixed exchange rate system to a manage float one. In the 1970s, Mauritius adopted a pegged exchange rate system where the rupee was first pegged to the sterling. The rupee started floating vis-à-vis other foreign currencies in June 1972 while still being pegged to the sterling. However as from 1976, the Mauritian rupee was delinked from the sterling and was pegged to the SDR. The rupee-SDR peg lasted for seven years and as from 1983 Mauritius pegged its currency to a trade-weighted basket of currencies. This is because the appreciation of the dollar US which had the highest weight in the SDR basket caused the rupee to appreciate considerably and hence causing inflation. Hence the Mauritian rupee had to be delinked to the SDR. In the 1990s, Mauritius embarked on a set of financial liberalisation reforms and in 1994 exchange rate controls were removed and Mauritius adopted a manage float exchange rate regime.

The evolution of the exchange rate system from a fixed to a manage float one implies that the exchange rate in Mauritius is subject to wider fluctuations. This begs the question whether the fluctuations in the rupee has any significant impact on the volume of trade in Mauritius and which of the theories advanced by researchers is applicable for Mauritius. Bilateral trade between Mauritius and USA is considered to assess this question. The rest of the paper is organised as follows:

Chapter 2 presents a broad survey of the literature concerning the relationship between trade and exchange rate volatility. Chapter 3 describes the model that will be used and presents the methodology that will be applied. Chapter 4 presents the empirical findings of our study and the interpretation of our results. Finally chapter 5 presents the summary and conclusion of our study and also provides some policy implications and implications.

2.1 Introduction

The 1970s saw the demise of the Bretton Woods system since a fixed exchange rate system no longer appeared feasible given the speculative flows of the currencies. This led to the adoption of a freely-floating exchange rate regime by many countries. Since March 1973, exchange rates have become more volatile and less predictable than they were during the fixed exchange rate period when changes occurred infrequently. There have been considerable investigations on the effect of Exchange rate volatility on the volume of trade. The increase in the risk of international transactions led researchers to investigate the exchange rate volatility-trade flows connection. Investigators argue that variability increases uncertainty and risk which causes firms to produce less than they would produce under certainty. This view was supported by Baron(1970), Clark(1973) and Ethier(1973). Empirical studies which yielded a negative relationship between exchange rate volatility and trade include Akhtar and Hilton(1984), Fountas and Aristotelous(1999), Arize(1997, 1998a and 1998b) and Rose(2000).

However other authors have rejected this view, arguing that the exchange rate volatility have very little or at times even positive impact on trade volume. Researchers like Hooper and Kohlhagen (1978), Bahmani et Tavlas(1988), Bahmani et al.(1993), Bailey, Tavlas and Ulan(1987), found evidence of a negative effect of exchange rate uncertainty on trade volume, the effect was insignificant. Klassen(2004) also found no significant relationship between Exchange rate volatility and international trade. Research conducted by McKenzie and Brooks(1997), Franke(1991), Neumann(1995), Viaena and Vries(1992) and Baum et al(2004) on the other hand found a positive relationship between exchange rate volatility and trade. Other researchers like Cushman(1983) on the other hand obtained mixed results.

This chapter provides an overview of the vast literature that covers this particular issue of exchange rate volatility and trade. Section 2.2.1 provides an overview traditional exports and imports functions used in most studies and their findings. Section 2.2.2 elaborates on additional factors which have been used in empirical studies. Finally section 2.2.2.4 outlines the research carried out to determine the relationship between exchange rate volatility and trade.

Literature defines volatility as the tendency of prices to fluctuate either up or down. Exchange rate volatility is in fact a measure of how exchange rate changes over time. It has been argued that exchange rate volatility has a significant impact of the level of trade. First we will discuss the various factors that have an impact of trade in an economy.

2.2 Determinants of Bilateral Trade Flows

Most of the empirical works used the traditional export and import demand models. While the traditional models were deemed to be significant in explaining trade, these works were often deemed to be unsatisfactory since several key determinants of trade were omitted which led to unreliable results and conclusions. Therefore, the traditional trade function was used in addition to other explanatory variables. Nevertheless, the major contribution of the traditional trade model in explaining exports and imports cannot be ignored.

2.2.1 Traditional Export Demand Function

The traditional export demand function commonly used by many studies was expressed as a function of real income, relative prices and/or exchange rate. This was termed by Goldstein and Khan (1985) as the imperfect substitute model. An aggregate export demand linking real exports with a measure of foreign real income and relative prices is an important element in most conventional trade models. In theory, the higher the foreign income, the higher the demand for export. This is because an increase in foreign income is relative to an increase in the purchasing power of the foreign economy. Likewise an increase in domestic income will increase the demand for imports. Real foreign income were normally proxied using real GDP or real GNP or index of industrial production of the foreign economy. Relative prices were also included in the model. Relative prices are an indicator of a countries competitiveness and are normally proxied by the ratio of foreign prices to domestic prices or the ratio of import prices to import prices. Exports and relative prices is expected to have a positive relationship since an increase in relative prices implies that foreign prices are increasing which means that the competitiveness of exports is increasing.

One of the most influential empirical work on export demand was that of Senhadji and Montenegro(1999) who estimated demand elasticities for a large number of developing and industrial countries using OLS and Phillip Hansens’s fully modified ordinary least square techniques. They found that exports react to both the trade partner’s income and to relative prices in a large sample of both developing and industrial countries. Marquez and McNeilly(1988) examined income and price elasticities for exports of non-OPEC developing countries using quarterly data for 1973-84. This study was based on the two-stage square estimation technique. Import prices, real income and lagged endogenous variables were the main explanatory variables. They found a positive and significant income elasticities for exports and a significant relationship between prices and exports. Among other prominent empirical works which find a positive and significant relationship between trade and income are Sachs and Warner(1995), Frankel and Romer(1999) and Edwards(1998). Wu(2004)constructed a foreign trade model for China using error correction model. They found a significant and inelastic relationship between relative price and export demand.

Other empirical works included exchange rate as a determinant of export in their model. It is widely known in the international trade literature that a change in real exchange rates will affect trade flows directly with all other things being equal. A change in the real exchange rate rather than a change in the nominal exchange rate will affect exports and imports under the Generalized Marshall-Lerner condition. Also real exchange rate is another important measure of a country’s competitiveness. Real exchange rate is the nominal exchange rate that has been adjusted for inflation differentials. A real depreciation or devaluation of domestic currency will lead to an improvement in trade flows of a country and vice versa. This is because if the price of the currency of a country is low, its exports will be cheaper hence demand for its exports will increase. Imports also will be affected since imports will appear more expensive to local residents. However empirical works have found diverging results when assessing whether exchange rate have any effects on trade.

Miles (1979) tested the effects of devaluation by entering the exchange rate directly into the trade flows. The results obtained were not conclusive since the exchange rate coefficient with respect to trade flows was significant in only three out of 14 cases examined. Warner and Kreinin(1983) specified the determinants of trade flows of 19 developing countries using conventional models. They found that the effect of real exchange rate changes on the volume of exports are significant as predicted by the theory. Similarly Himarios(1989) reassessed the impact of devaluation on real magnitude of trade flows and found that real exchange rates had a significant effect on trade flows. Rose (1991) analysed the relationship between the effective real exchange rate and the real trade flows for five major Organization for Economic Cooperation and Development (OECD) countries: the United Kingdom, Canada, Germany, Japan, and the United States. He found no relationship between these two variables, and thus the generalized Marshall-Lerner condition did not hold.

Bahmani-Oskooee and Malixi (1992) based their work on Almon lag structure on real exchange rate but found no support for a relationship between trade and real exchange rate. However on employing the Engle-Granger cointegration approach, Bahmani-Oskooee and Alse (1994) assert that the long-run impact of devaluation on the trade balance model is positive. Bahmani-Oskooee concluded that trade flows are more responsive to changes in relative prices and to changes in the exchange rates in the long run than in the short run. Brada et al. (1997), who divided the data set into two sub-samples, reports no long-run relationship between the variables of the trade balance function in the 1970s but they have revealed reverse results for the 1980s

Kale (2001) points out that a real depreciation of the domestic currency helps to improve the trade balance with a lag of about one-year and the impacts of devaluations on the trade balance are positive in the long-run.

Haque et al.(1990) used a generalised non-linear 3-staged least square estimation for the period 1963-87. They used a conventional model where real imports is expressed as a function of real domestic output, real exchange rate and a lagged import term. All signs were significant. Real imports were found to be real exchange and income inelastic. While the above factors were used as the main determinants of exports, there are also other also factors which are important determinants of trade.

2.2.2 Other factors affecting bilateral trade

2.2.2.1 Inflation rate and trade

Inflation is defined as a rise in the general level of prices of goods and services in an economy over a period of time. High inflation is like to have a negative effect on trade flows because it reduces exports competitiveness and makes imports cheaper. When domestic price rises, foreign goods are relatively cheaper (ceteris paribus) and demand for imports should increase, Inflation adversely affects some sections of the population, distorts relative prices, erodes value of financial assets and creates uncertainty and instability in the economy. This may lead to an overall decrease in output in the economy since investors and producers is faced with uncertainty about future prices and economic outcome. Gylfason(1998) used cross-sectional data covering 160 countries for the period 1985-1994 and found that high inflation tended to be associated with low exports in proportion to GDP. Kotan and Saygili(1999) found that inflation rate significantly and positively affect non-oil exportation in the long-run while in short run inflation did not have any significant impact of non-oil production.

2.2.2.2 Investment and Trade

     There are valid theoretical reasons why a high investment ratio should give rise to a strong export growth performance. One theoretical background is provided by Ghosh and Chandrasekhar(2001). They stated that the rate at which international trade grows varies over any period. Also a country’s ability to increase its exports would depend on its production structure and the rate at which this structure is changing. Furthermore, countries normally engage in international trade by XXXodernizesXXXg in the production of certain commodities only. Therefore a country’s ability to increase its exports will therefore depend on its capacity to rapidly transform its production structure in the direction of commodities where world trade would grow faster. The rapidity of this transformation is linked to the investment ratio(ratio of investment to GDP), that is the higher the investment ratio, the higher the rate of transformation of the production-structure and hence the greater the ability of the country to participate in world trade, that is the greater the rate of export growth.

Also production capacity, potential productivity, cost effectivesness, production process will all be increased by properly-oriented investment and hence export competitiveness should also increase. Investment is said to enlarge the production base and thus increasing production capacity. It XXXodernizes production processes and thus improving cost effectiveness. It also allows for the production of new and improved products, increasing value added in production. In addition it incorporates international world-class innovations and quality standards. All this leads to an active participation in international trade and favourably affects exports.

Patnaik and Chandrasekhar(1996) in their research analysed cross sectional data for 25 developing countries for 20 years and found a positive relationship between investment-ratio and export growth. FDI is said to foster innovation and competitiveness in the local industry. Moreover it contributes to technological innovation and increased production capacity in the domestic economy. Another import element of investment is foreign direct investment(FDI) which has been argued to be a prominent factor in promoting exports. Horst(1972), Lipsey and Weiss(1984), Head and Ries(2001) and Camarero and Tamarit(2004) are among the authors that find a positive relationship between FDI and trade.

2.2.2.3 Capacity Utilisation and Trade

Capacity utilization refers to the extent to which an enterprise or a nation actually uses its installed productive capacity. Thus, it refers to the relationship between actual output that is produced with the installed equipment and the potential output which could be produced if capacity was fully used. From theoretical and empirical point of view, the relationship between capacity utilisation and exports is ambiguous. On one hand, researchers argue that when firms uses excess capacity, this will increase to a general increase in capacity utilisation and will lead to an increase in output. It will be possible for firms to export more. Productivity also may increase since firms are employing more of their excess capacity. Likewise an increase in foreign capacity utilisation is likely to have a negative impact on domestic exports. This is because an increase in foreign capacity utilisation means firms are able to increase their productivity and output. Also Hooper and Kohlagen(1978) who were the first to introduce capacity utilisation in their model to determine the relationship between exchange rate volatility and exports, argued that as domestic capacity utilisation increases, domestically produced goods are delivered with longer lags and hence decreasing quantity demanded of imports. Likewise an increase in foreign capacity should decrease the demand of exports. Correa, Dayoub and Francisco(2007) in their study found that domestic capacity utilisation positively affect export intensity of Ecuador. On the other hand other authors argue that exports growth is possible mainly in the presence of large unemployment of domestic resources. Dunlevy(1979) and Artus(1977) argued that in the long run an increase in capacity utilisation will reduce the quantity of exports and increase the export prices. However Medhora(1990) found that both domestic and foreign capacity utilisation was insignificant in explaining West African imports.

2.2.2.4 Exchange Rate Volatility and trade

Basic uncertainty trade models

     The traditional models examine the behaviour of undiversified firms and are based on the assumption that the firm’s profitability is linked directly and unambiguously to the movement in one bilateral exchange rate. The variability of that exchange rate is assumed to measure the risk to the firm in conducting trade. Therefore in the simplest model, higher exchange rate risk is assumed to have a negative impact on trade, since it creates uncertainty with respect to profits of firms’ exports and, hence, lead risk-averse exporters to reduce their supply of exports, an effect that increases with the degree of risk aversion.

     An example provided by Clark(1973) can be used to illustrate the concept of how exchange rate volatility can affect the level of a firm’s exports. Clark develops a model of a firm operating under competitive conditions. In the simplest version described, it is assumed that the firm produces a homogeneous commodity which is sold entirely in a foreign market. The firm has no market power and its does not import any inputs and the production decision is taken before observing exchange rate volatility, therefore output is constant over the planning horizon. Also the price of the exported good in foreign currency is an exogenous variable. The firm in paid in foreign currency and hedging possibilities such as forwards or futures market is very limited. The firm converts its proceeds from exports at the current exchange rates. Given the above assumptions, variability in the exchange rate will affect the firm’s level of profits since output cannot be altered in response to a favourable or unfavourable move in the profitability of exports due to exchange rate movements and there are also limited hedging techniques. Therefore uncertainty about future exchange rates translates into uncertainty on future export receipts in domestic currency. This uncertainty will be considered by the firm when deciding on the level of exports. The firm maximises the expected value of utility which is assumed to take the following quadratic form: U(p)= a p +b p2

Under conditions of risk aversion (b < 0), the first-order condition requires that marginal revenue exceed marginal cost. The firm must be compensated for the exchange risk it bears and thus the supple curve shifts towards the left and the volume of production and trade is reduced. A risk-averse firm tries to reduce its exposure to risk by reducing sales, hence both expected profits and the variance of profits decline, but expected utility increases. If inputs were imported, the contraction in the supply of exports would be smaller. The variance in profits would not rise in proportion to the increase in the variance of the exchange rate. Only in the extreme case of perfect correlation between revenues and costs in domestic currency terms would greater variability have no effect on the variance of profits. Ethier (1973) also supported this view and shows that, if traders were uncertain as to how the exchange rate affects their firms' revenue, the volume of trade will be reduced.

     However the above analysis is based on a number of restrictive assumptions. Other researchers attempted to examine the relationship between exchange rate variability and trade flows by relaxing some of the assumptions like no hedging possibilities while still maintaining the risk aversion theory. Clark (1973) notes that while risk-aversion among traders might depress the volume of a country’s exports, perfect forward markets might reduce this effect. Advanced economies have well developed forward markets where specific transactions can be easily hedged, thus reducing exposure to unforeseen movements in exchange rates. However most developing countries do not have access to such markets for currencies. Baron (1976) finds that forward markets may not be sufficiently developed, and traders may still be unsure of how much foreign exchange they want to cover. In addition, Baron provides another approach to the model developed by Clark by relaxing the assumptions of perfect competition and by emphasising on the role of the currency in which the products are invoiced. He argues that invoicing in a foreign currency will result in a price risk. When an exporting firm invoices its commodity in foreign currency, it is faced with the risk of variations in the foreign exchange which will affect revenue. The quantity demanded will however remain the same since the price will not change over the contract period and hence the firm cannot benefit from fluctuations in the foreign exchange rate. When invoicing in home currency, the exporter will face a quantity risk. This is because the quantity demanded will be uncertain since the price of the commodity to the buyer will be uncertain. The firm will also face uncertainties regarding its cost of production since the assumption that the firm will not import factor inputs is relaxed. In both cases the risk averse firm will try to minimise its risk exposure either by expanding or contracting supply. Baron shows that an increase in risk will cause prices to rise which will result in an increase in supply. The higher price reduces expected profits since demand is elastic at optimal prices, but it increases expected utility. On the other hand, if the firm invoices in domestic currency, its response will depend on the properties of the demand function in the destination market. Baron shows that if the function is linear, prices will decrease resulting in an increased demand. However the price-cost margin decreases which reduces the expectation and variance of profits.

Also, under the basic model, changes in exchange rate does not have any effect on real opportunities available to the firm. Firms are held to be risk averse and factor inputs are assumed to be fixed. They are also assumed to make production and export decisions before the exchange rate is known and inventories are ignored. When the assumption of risk aversion is lifted, the negative relationship between exports and exchange rate volatility can even be reversed. De Grauwe(1988) developed a model that shows that the effect of volatility on trade will depend on the degree of risk aversion. He argued that firms with a slight degree of risk aversion will decrease their exports whereas very risk averse firms will increase exports so as to avoid a drastic decrease in their export revenues caused by higher exchange rate volatility. Franke(1991) showed in given a monopolistic setting, risk neutral firms may increase exports if exchange rate volatility increases. The theory that trade may be affected by exchange rate volatility is also based on the assumption that factor inputs cannot be altered so as to adjust optimally to a change in exchange rates. If firms are able to adjust one or more factors of production with respect to a change in exchange rates, variations in exchange rate may provide firm with the possibility of making a profit. This view was analysed by Canzoneri et al.(2004), De Grauwe(1992) and Gros(1987).

In addition, Clark et al.(2004) affirm that there are several other factors which can reduce the negative effects of exchange rate volatility and trade. They argued that a multinational firm which engages in a diversity of trade and financial transactions across several countries can benefit from various opportunities to exploit offsetting movements in currencies and other variables. For example if an exporting firm is importing intermediate inputs from a country whose currency is depreciating, this can offset a decrease in export revenues through a decrease in cost of production. Also recent studies has shown that the tendency for exchange rates to adjust to differences in inflation rates and hence if exports are priced in a foreign currency that is depreciating, the loss to the exporter from the declining exchange rate is at least partly offset by higher foreign currency export price(Cushman 1083 and 1986) Finally as put forward by Makin(1978), multinationals have many possibilities of internally managing their exposure to foreign exchange risk, for example by holding a portfolio of assets and liabilities in different currencies.

In his analysis of exchange rate volatility, Gros(1987) takes into account adjustment costs. His model consist of a risk neutral and competitive firm which exports its entire output. It is shown that if some factor can be adjusted instantaneously, an increase in exchange rate volatility increases a firm’s investment. The rationale behind this is that if exchange rate for the exporting firm is high, this means output price will be high and thus the firm can increase production by utilising more of the flexible factor so as to obtain a more than proportionate increase in profits. On the contrary if prices are low, production can be reduced to limit losses. An increases in the volatility of prices means that there is the possibility for excessive prices increases. Therefore it is more desirable for firms to have high capital stock and over time the export supple function shifts upwards. In this study, exchange rate variability affects exports through its effect on investment.

Another aspect of the relationship between exchange rate variability and trade is the presence of sunk cost. Sunk market-entry costs are faced by risk neutral firms when they enter the market for exports. This would arise particularly where the firm is exporting differentiated goods and require substantial investment by the firm for example to adapt their product to foreign market and to create a marketing and distribution network. Sunk cost tend to make firms less responsive to short run fluctuations in the foreign exchange rate as they would have the tend to continue to operate in the market as long as they can recover their variable costs and to wait for a change in the exchange rate which will allow them to recoup their sunk costs((Baldwin,1988; Krugman, 1989)

Finally, other researches like Bacchetta and Van Wincoop (2000) conduct their study within a general equilibrium framework. They use a simple general equilibrium model for two countries where the source of uncertainty are monetary, fiscal, and technology shocks, and they compare the level of trade and welfare for fixed and floating exchange rate arrangements. They reach two main conclusions. First, there is no clear relationship between the level of trade and the type of exchange rate arrangement. Second, the level of trade does not provide a good index of the level of welfare in a country, and hence there is no one-to-one relationship between levels of trade and welfare in comparing exchange rate systems.

Theoretical analysis of the relationship between exchange rate volatility and trade flows has yielded indeterminate results and hence this issue has attracted a large number of empirical researches. One of the earliest analysis was carried out by Hooper and Kohlhagen(1978) who assessed the effect of exchange rate volatility on the volume of aggregate and bilateral trade flow for all G7 countries except for Italy using time series data for the period 1965-1975. They utilised the model by Ethier(1973) for traded goods and derived equations expressing export prices and quantities in terms of cost of production reflection both domestic and imported inputs, other domestic prices, domestic income and capacity utilisation. Exchange rate risk was measured using the average absolute difference between the current period spot exchange rate and the forward rate last period, as well as the variance of the nominal spot rate and the current forward rate. Their conclusion was that they found no significant effect of exchange rate risk on the volume of trade.

     Cushman(1983) uses a model similar to Hooper and Kohlhagen to investigate the effect of exchange rate uncertainty on trade flows among industrialised countries. However he enhances the model by extending the sample size to include more recent data and by using real rather than nominal exchange rate. Of the 14 sets of bilateral trade flows, Cushman found a significant negative effect of real exchange rate on trade flows in 6 cases against only 2 cases where the association is statistically significant and positive. Along the same line Bailey and Tavlas(1988) did not find any significant evidence of a negative effect of exchange rate variability on trade.

     The work of Akhtar and Hilton(1984) were among the few early papers which generated fairly consistent results. They derived volume and price equations for Germany and United States multilateral trade for the period pertaining to a floating exchange rate. Exchange rate volatility was measured in terms of the standard d


To export a reference to this article please select a referencing stye below:

Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.

Request Removal

If you are the original writer of this dissertation and no longer wish to have the dissertation published on the UK Essays website then please click on the link below to request removal:


More from UK Essays