We analyze the relation between exchange-rate volatility and the volume of international trade, in a general-equilibrium stochastic-endowment economy with imperfect international commodity markets, and treating both variables as endogenous. Even in the simplest model, the sign of the relation depends on the source for the change in volatility. For instance, more volatility of the endowments and higher costs to international trade both boost exchange risk (and lower welfare); but the first increases the expected volume of trade, while the second decreases trade. Note that even the (inter-equilibria) relation between trade and welfare is ambiguous.
Our objective in this paper is to evaluate the conjecture that an increase in exchange rate volatility is associated with a decrease in the volume of international trade. Perée and Steinherr (1989) argue that the existing literature on exchange rate volatility and international trade suffers from two weaknesses: first, the existing theoretical models – for example, De Grauwe (1992), Franke (1991), Sercu (1992), and Viaene and de Vries (1992) – are partial equilibrium in nature, and second, in the empirical work a linear relation between trade and exchange rate risk is postulated while the true relation might be non-linear.1 The model we develop is of a general-equilibrium economy with stochastic endowments in which the exchange rate and the prices of financial securities are determined endogenously. Our major result is that in this general-equilibrium setting an increase in exchange-rate volatility may be associated with either an increase or a decrease in the volume of international trade, depending on the source of the change in volatility.
We now discuss the existing literature on the relation between exchange rate volatility and international trade, starting first with an overview of the theoretical models and then a survey of empirical work.2 In the early theoretical literature, a number of models support the view that an increase in exchange rate volatility leads to a reduction in the level of international trade. These models (for example, Clark, 1973; Baron, 1976a; Hooper and Kohlhagen, 1978; Broll, 1994; Wolf, 1995) consider firms exposed to exchange risk. A typical argument in this literature is that higher exchange risk lowers the risk-adjusted expected revenue from exports, and therefore reduces the incentives to trade. However, these results are derived from partial-equilibrium models. Also, most of this literature assumes that the exchange rate is the sole source of risk for the decision-maker, and either ignores the availability of hedges (forward contracts, or non-linear hedges like options and portfolios of options) or takes the prices of the hedge instruments as given.
Taking into account the firm's option to (linearly) hedge its contractual exposure, other partial-equilibrium models such as Ethier (1973) and Baron (1976b) show that exchange rate volatility may not have any impact on trade volume if firms can hedge using forward contracts. Viaene and de Vries (1992) extend this analysis to allow for the endogenous determination of the forward rate; in this case, exchange rate volatility has opposing effects on importers and exporters (who are on opposite sides of the forward contract) and they find that the net effect of exchange rate volatility on trade is ambiguous. Also De Grauwe (1988) shows that risk aversion is not sufficient to obtain a negative link between exchange risk and expected trade because, in general, an increase in risk has both an income effect and a substitution effect that work in opposite directions (Goldstein and Khan, 1985). Dellas and Zilberfarb (1993) make a similar point using a portfolio-choice model.
While these models allow the firm to hedge or at least diversify its exchange risk, they still ignore the firm's option to adjust its production in response to the exchange rate. Models that focus on the firm's flexibility tend to conclude that a higher exchange risk actually stimulates trade. The reason is that, when firms are allowed to optimally respond to exchange rate changes, the revenue per unit of an exportable good (De Grauwe, 1992; Sercu, 1992) or the entire cashflow from exporting (Franke, 1991; Sercu and Van Hulle, 1992) become convex functions of the exchange rate. From this it follows that the expected unit revenue or the expected cashflow increases when the volatility of the exchange rate increases. These models, however, still take the demand functions or the cashflow function as given, and therefore ignore how the demand or cashflow function is affected by changes in the economy that are the cause of an increase in exchange risk. Moreover, these models treat the exchange rate as exogenous, and therefore independent of the actions of the average firm.
We now discuss some of the empirical work studying the relation between trade volume and exchange rate volatility.3Koray and Lastrapes (1989) use VAR models to examine whether exchange rate volatility affects the volume of trade. They find that exchange rate volatility explains only a small part of imports and exports. In cross-sectional tests, Brada and Mendez (1988), using a gravity model of bilateral trade, find that even though exchange rate volatility reduces trade, its effect is smaller than that of restrictive commercial policies. Frankel and Wei (1993), using an instrumental-variables approach, also conclude that the effect of exchange rate volatility on trade is small. On the other hand, Asseery and Peel (1991) using an error-correction framework, and Kroner and Lastrapes (1993) using a multivariate GARCH-in-mean model, find that an increase in volatility may be associated with an increase in international trade, while McKenzie and Brooks (1997) even find a clearly positive association. Thus, the overall conclusion is that the effects of exchange rate volatility, if present, are small, and not always negative.
To examine the relation between international trade and exchange rate volatility in a framework that does not have the limitations of the theoretical models discussed above, we need a general-equilibrium model of the aggregate economy. Accordingly, our objective is to develop a general-equilibrium model where commodity markets are segmented so that there are deviations from Commodity Price Parity and changes in the real exchange rate. We model this segmentation by introducing a cost for transferring goods across countries – as in Samuelson's iceberg model of trade – similar to the recent work of Dumas (1992) and Sercu et al. (1995). Financial markets, in contrast, are assumed to be complete and perfectly integrated, reflecting the fact that, at least for developed economies, international capital markets are far less subject to restrictions than commodity markets. Thus, in our model consumers can make cross-border financial investments to finance or hedge future imports; likewise, firms can make optimal hedging decisions; and the prices of all contracts are determined in a general-equilibrium framework.
The rest of the paper is organized as follows. In Section 1, we describe the economy that we use in our analysis. In Section 2, we show that in our one-good setting the relation between exchange rate volatility and the volume of international trade is positive when output risk increases, and negative when the shipping cost increases. We conclude in Section 3.
In this paper, we examine the conjecture that exchange-rate volatility is associated with a decline in trade. We do this by developing a model of a stochastic general-equilibrium economy with international commodity markets that are partially segmented because of shipping costs. In contrast to existing work on the effects of exchange rate volatility on trade, in our model the exchange rate is determined endogenously in a complete financial market.
We argue that because both trade and exchange rate volatility are endogenous quantities it is misleading to relate one to the other as if one of them were exogenous. We show, via two examples, that even in a very simple model it is possible to have either a negative or a positive relation between trade and exchange rate volatility, depending on the source underlying the increase in exchange rate volatility.
