V Summary and Concluding Remarks

Peter Clark, Shang-Jin Wei, Natalia Tamirisa, Azim Sadikov, and Li Zeng
Published Date:
September 2004
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This study provides a much more comprehensive analysis of exchange rate volatility and trade than the previous IMF analysis. 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.

The lack of a robustly negative impact of exchange rate volatility on trade may well reflect the ambiguity of the theoretical results in the general equilibrium models. These models show that exchange rate variability is the result of the volatility of the underlying shocks to technology, preferences, and policies, for example, as well as the overall policy regime. Changes in the volatility of the exchange rate may reflect changes in the volatility of the underlying shocks and/or changes in the policy regime. For example, trade liberalization undertaken together with a move to greater exchange rate flexibility could well be associated with increased trade flows as well as increased exchange rate volatility. This possibility is a reason for the ambiguity of the theoretical results as well as the difficulty in finding consistent and robust empirical results regarding the impact of volatility on trade. An additional implication is that the empirical results do not provide clear policy guidance. Even if such volatility were associated with reduced trade flows, this does not necessarily mean that trade would expand if the authorities stabilized the exchange rate in the face of shocks that occur.

These considerations suggest that there are no strong grounds upon which to take measures to reduce exchange rate movements from the perspective of promoting trade flows. Note that this does not rule out the possibility that exchange rate fluctuations may affect an economy through other channels. For example, currency crises—special cases of exchange rate volatility—have required painful adjustments in output and consumption. In this case, however, appropriate policies are those that help to avoid the underlying causes of large and unpredictable movements in exchange rates, rather than measures to moderate currency fluctuations directly for the purpose of enhancing trade.

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