Impact of Exchange Rate Volatility on Trade Flows Essay

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Exchange Rate Volatility on Trade Flows

Exchange Rate Volatility

Impact on International Trade Flows

Exchange Rate Volatility

Impact on International Trade Flows

Bretton Woods

Trade Flow

Trade Flow Responsiveness

Commodities

The dissolution of the Bretton-Woods system in 1973 introduced a new era for international markets. No longer would the exchange rates be pegged and fluctuating exchange rates changed the game for international trade and investment. The newly introduced increase in volatility in the foreign exchange markets also increases the risk of uncertainty for all international transactions. The floating rates produce new complexities that have implications for any individual or organization who buys sells, makes, or trades goods or currencies. These implications directly affect nation's balance of trade; however they also literally indirectly affect every individual's lives in one way or another.

The exchange rate volatility has had mixed theories produced by academia in terms of its effects on trade flows. It appears that McKenzie sparked much interest in the field since he published his findings in 2009. He found by conducting a meta-analysis of that there was little statistical significant support to suggest that volatility affects the overall trade volume. Since his work was published, many other scholars have produced works with similar results while others have found implications that tend on the whole to be market and industry specific.

The mixed result provided by these sources leaves one continuing to speculate what effects upon trade flows the exchange rate volatility might have. Some studies have produced evidence that when data is disaggregated to industry level analysis, it shows that significant effects from volatility while others studies produce minimal evidence. However, though disaggregated market information provides more insightful looks into specific markets and trade flows, the data in this case produces mixed results as well.

Bretton Woods

It is important to understand the foundation in the historical context of the Bretton Woods system to fully understand the current academic debate. The Bretton Woods system was enacted after the end of the Second World War when the United States emerged as the last remaining superpower. The U.S. leveraged their supremacy as the dominant world economy, continued it's the gold standard, and offered international countries the confidence needed to peg their exchange rates to the dollar. Since the dollar was the strongest currency available after the war and its production levels were comparatively high in regards to other economies, the U.S. was able to achieve its position as the world's dominant currency.

The U.S. kept this position into the early nineteen seventies in which it faced increasing pressure from the expanding European economies as well the Japanese economies to unpin to fixed exchange rates. This coupled by an inflationary period in the United States led to a trade deficit and consequently an outflow of gold making the system unstable. The system was finally fully dismantled in February of 1973.

Trade Flow

Post Bretton Woods, floating interest rates were thought by many to preclude a decrease in international trade activity (McKenzie, 1999). The increased risk in exchange rate uncertainty was thought to lead to decreased amounts of trade. The assumption was that the increased risk would decrease the incentive to engage in international trade. From the perspective of the individual considering such a transaction, increased risk should bring a monetary premium or the deal would simply not be beneficial. The requested premium would shift the supply curve to the right and consequently a reduced amount of demand for product would be realized by the producer. As an aggregated effect this would decrease the amount of bilateral flow between countries.

However, another opposing theory emerged as well. This theory stated that the increased volatility in exchange rates would provide an incentive for firms to increase the velocity in which international transactions occurred (Hegerty, 2007). Therefore this could act as a catalyst to increase the amount of trade. Again from the producer's perspective, if exporting acted as a keystone to the business plan then these producers would look to minimize the effects of the interest rate volatility.

One method of achieving this would be to schedule transactions and exchange predictions in the narrowest time frame available. This increased sense of urgency could then act to facilitate an increase in trade velocity and also lead to an overall increase in the trade volume. Almost as if the floating exchange rate acted as a lubricant which increased the time factor in the trading mechanisms.

One study looked at the volatility in exchange rates over an extended period, using monthly data from January 1974 to July 2000 to examine effects on imports in the UK (Cheong, 2004).

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The study finds a statistically significant negative correlation between the risk associated with fluctuating exchange rates and import trade to the UK. This is significant because a bulk of the trading that the UK is engaged with comes from other members of the European Union. Furthermore, the study suggests that if the UK were to adopt the EURO as the currency then the UK could potentially benefit from mitigating the negative correlation by adopting the single currency of the European Union. However, this would only act to reduce risk on one front; the volatility risk of the pound would also fluctuate among other currencies such as the dollar.

Trade Flow Responsiveness

Another aspect to considering the effects of floating exchange rates on trade flows is how fast the trade flow reacts to a change in exchange rates. A country could utilize tools such as the imposition of tariffs to restrain imports or provide subsidies to stimulate exports; however they could also theoretically use currency devaluation to achieve a similar end. One study looks at the speed in which trade flows respond to exchange rate changes in nine different developed countries (BAHMANI-OSKOOEE & KARA, 2003).

The study looked at Australia, Austria, Canada, Denmark, France, Germany, Italy, Japan and the U.S. It found that there was not one common rate of responsiveness among these developed countries and that each country exhibited different responses to exchange rates in the period studied from 1973 to 1998. Implications in regards to foreign policy may be hence drawn from such lines of question however it appears only to be relevant on a disaggregated and country specific level as no international trends emerged.

Commodities

The commodities market offers an opportunity to consider how volatility in exchange rates affect undifferentiated products. This lack of product differentiation makes this particular market one that should be worthy of an economists attention. The fact the quality is not a considerable factor in the consumer's eye, make the commodities market what one could consider a pure market. Therefore, if a study was conducted on international trade, the commodities market could act as a solid foundation for research. These markets are generally considered to be the closest form to perfect competition that is know in real life exchanges.

One study disaggregated data (Bahmani-Oskooee & Wang, 2008) from a number of previously conducted studies at the commodity level that trade between the United States and Australia. This allows for some of the most accurate exchange rate modeling of the purest markets imaginable. The study found that short run implications among exchange rate fluctuations were felt among a majority of firms (roughly sixty percent). However, the short run implications only transgressed into long-term effects in a very limited number of industry specific cases. Furthermore, the study found that the U.S. was more sensitive in importing during exchange rate fluctuations while Australia was conversely more sensitive to exporting.

Another study expands on the commodities approach by considering how volatilities in exchanges rates may influence commodities prices which in turn also affect non-trade items (Tokarick, 2008). Before this consideration had been made most studies have focused only on the trade flows and have omitted any notion of how non-trading good prices may be affected by exchange rates. An increase in the price of imported commodities should consequently have an impact upon the income effect of individuals depending on the level of substitution of that particular good. Though this does not directly impact trade volumes, it could potentially indirectly affect other markets in the interwoven economic stability of a country.

Conclusion

Since the dissolution of the Bretton Woods system of pegging foreign exchange rates to the U.S. dollar, many researchers have yet to pinpoint the effects of fluctuating exchange rates upon the global economy. Results of analysis seem to differ by the level of examination. For instance, when looking at specific industries within specific national economies, some evidence may appear to be significant. However, in other cases it appears that specific industries absorb shocks entirely within themselves by companies acting on individualized strategies that produce a null affect on the industry as a whole.

Theoretically it seems plausible that increases in risk due to fluctuating exchange rates would cause risk adverse international traders to decrease investments internationally and move resources to focus on the domestic market. However, the research on the topic offers nothing conclusive to support….....

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