Fluctuations in exchange rates have been large and frequent in the floating exchange rate period. The response of trade flows and current accounts to these fluctuations, however, has been limited. This seems at odds with the traditional view that the real exchange rate is a principal determinant of the volume of trade. Movements in the dollar and the U.S. current account provide an interesting example. The dollar appreciated by about 50 percent with respect to a basket of currencies in the span of five years (1980-85), and then fell to its 1980 value in only three years. In the meantime, the U.S. current account deficit soared and then continued to widen despite the huge dollar depreciation that followed the Louvre and Plaza agreements. The slow and confused response of trade flows to exchange rate changes is difficult to explain even after allowing for J-curve effects, information and transportation lags, and the increased uncertainty resulting from higher exchange rate volatility.
The persistence of trade imbalances, in particular between the United States, Japan, and Germany, and their apparent unresponsiveness to exchange rate changes, have led to a re-examination of the traditional adjustment processes. There have been a number of attempts to explain this persistence by allowing for a combination of strategic interaction in oligopolistic markets, sunk costs, and uncertainty in foreign trade. It has been argued that these factors adversely affect the working of the adjustment mechanism and cause hysteresis in trade flows, for example, by making trade flows dependent not only on the current value of the exchange rate but also its past history.
This paper attempts to examine the issue from an econometric point of view by distinguishing two types of hystereses: that arising from limited exchange rate pass-through and that arising from regime switches in supply. It starts with a benchmark model where export prices and quantities are determined along traditional lines, and then develops a model where the presence of sunk costs generates discontinuous behavior by individual firms. Such a behavior at the firm level gives rise to nonlinearities at the aggregate level. The models are then estimated using data for the United States, Japan, and Germany. The paper finds strong evidence in favor of the presence of pricing-to-market and hysteresis only in the case of Japanese exports.