The Uncertain Cost of Uncertainty: An Inquiry into Exchange Rate Volatility and Bilateral Trade Flows

Abstract

The literature on exchange rate volatility and trade burgeoned following the collapse of the post-World War II Bretton Woods monetary system. After five decades of study, the relationship between currency fluctuations and bilateral trade remains unclear. This paper seeks to contribute to that literature by studying exchange rate volatility from several perspectives. The objective is to present findings that will be of interest both to academics and to policymakers. Controlling for several factors that explain variability in trade, this thesis finds that longer-term exchange rate volatility has a substantial negative effect, while shorter-term fluctuations have an ambiguous effect, if any. Specialized manufactured goods are found to be more susceptible to volatility than homogenous goods, although the result may not be robust to model specification. Countries with deeper foreign exchange derivatives markets experience substantially lower currency volatility and higher trade, but the interaction between hedging and volatility appears reliant on country-specific initial conditions. While currency misalignments are not correlated with volatility, a depreciated real exchange rate is found to considerably benefit exporters—that said, competitive devaluations may not mitigate the negative trade effect of high volatility. Policy implications and proposals for further study are included throughout.