The Theoretical Relationship between Exchange Rate Volatility and International Trade - Literature review Example

al Affiliation) EXPLAIN THE THEORETICAL RELATIONSHIP BETWEEN EXCHANGE RATE VOLATILITY AND INTERNATIONAL TRADE AND EVALUATETHE EMPIRICAL EVIDENCE TO JUDGE WHETHER THEORY IS BORNE OUT IN PRACTICE In the previous decade, the United States announced that the fix exchange rate had been collapsed under the Bretton-Woods system. Rose (2004, pg. 27) defines exchange rate volatility as ‘risk associated with unexpected movements in the exchange rate.’ Ortega & Giovanni (2005, pg. 14) stated that the floating exchange rate had caused significant volatility in some currencies of the developing countries. In a traditional point of view, people thought that the floating rate is uncertain and reduced the incentive to trade in the foreign market. This essay aims to discuss the theoretical relationship between exchange rate volatility and international trade, which are based on three implications, including risk aversion, trade volume and sunk costs. In order to interpret the correlations of the above theoretical relationship, the empirical evidence will be explained in three dimensions, including using co-integrating regression, Johansen’s co-integration and panel data in order to judge whether the theory can be consistent inconsistent. This will be based on the results. Based on the above definition of exchange rate volatility, we can conclude that currencies fluctuate everyday in a limited period of time. The exchange rate volatility is derived either from the nominal or the real exchange rate. According to Aizenmann (2002, pg. 21), there was a change in the exchange rate between Deutsche marks and US dollar between 1974 and 1994. Meanwhile, there was a dramatic appreciation of the US dollar against the Deutsche marks between 1980 and 1985. In that period, the US dollar calls for the country to increase the propensity so that US residents will spend money on domestic goods and expand foreign goods. Therefore, the fluctuation in the exchange rate affects the international trade such as import and export. In addition to the example of exchange rate volatility in the US, there is a theoretical relationship between exchange rate volatility and international trade. IMF (2004, pg. 34) has argued that higher exchange rate volatility results in a higher cost for risk-averse traders, and in turn negatively affects international trade. This is indicated by a decrease in the volume of trade for most commodities. The exchange rate is determined at the time an investor signs the trade contract, which means that future delivery happens when the investor has already confirmed the payment. However, IMF (2004, pg. 38) has argued that the fluctuation exchange rate is unpredictable, and therefore profits tend to become uncertain and cannot be estimated accurately. Consequently, international trade is simultaneously reduced. IMF (2004, pg. 39) provides an example of exchange rate volatility of thirteen developing countries. In this scenario, the exchange rate risk cannot be avoided because the forward market is not completely accessed to all investors. If the exchange rate risk exists in the forward markets, there are limitations and costs such as contract problems. Since the size of the contract is usually large, the maturity is short. As a result, traders find it hard to predict the magnitude and control the time of the entire foreign trade in order to gain an advantage in the forward market. Secondly, a recent research by Rose (2004, pg. 29) has indicated that exchange rate volatility can be anticipated to have positive or negative results on trade volume. The income effect has a higher priority than the substitution effect so the correlation shows that there is a positive relationship between trade and exchange rate volatility. As long as exporters are sufficiently investing conservatively, there will be an increase in volatility exchange rate, which leads to a rise in the marginal utility of export revenue. Owing to this, exporters increase the volume of exports immediately. The influence of exchange rate uncertainty on exports is therefore determined by the degree of risk aversion. Thirdly, Sercu & Uppal (2000, pg. 56) have put forward the theory that the uncertainty of higher exchange rate volatility influences the foreign trade in the aspect of sunk costs, which plays an important role in international transaction. One of the main aspects is that the firms need to pay the set up cost in the foreign market and also adapt to sell the products in foreign markets. Meanwhile, the sunk costs make the firms less sensitive to short-term movement in the exchange rate. Since the exchange rates are uncertain in the market, price and quantity are the main factors that affect the market share. Sercu & Uppal (2000, pg. 72) has claimed that firms observe and stay in the export market until the variable cost can be recovered. Once the exchange rate reaches a peak, the sunk cost can be recouped and the firms can easily have a transaction in the foreign market. In order to verify the theoretical relationship between change rate volatility and international trade, Aizenmann (2002, pg. 11) has elected to use the long run equilibrium equation of co-integrating regression in order to show that exchange rate risk has an adverse effect on US import in the empirical research conducted 1974. The exchange rate volatility causes higher risk and uncertainty in international trade. The empirical result is consistent to the theoretical relationship by IMF (2004). In the empirical research, Aizenmann (2002, pg. 19) has used co-integration to prove that if the dollar appreciates the exchange rate results in an increase in imports. However, Rose (2004, pg. 83) has argued that the exchange rate volatility has no effect on imports. Dickson has used the Johansen co-integration model of Augmented Dickey-Fuller test validate the result. Based on the result, a devaluation of a policy reduces the trade balance but cannot reduce the amount of import. Also, there is no relationship between the exchange rate risk and imports. The result is inconsistent with the theoretical relationship by IMF (2004, pg. 81) because higher exchange rate volatility has a direct adverse effect on international trade. In some countries, however, this is not replicated. Nigeria is an example. Moreover, IMF (2004, pg. 86) has used Johansen’s co-integration framework to prove that exchange rate volatility has an influence on imports and exports in Uzbekistan country. This was no more evident from 1999 to 2009. In the case of Uzbekistan, IMF (2004, pg. 92) used a co-integrating vector to test the theoretical relationship of exports and imports quarterly in each of the 10 years. The co-integrating vector particularly focuses on foreign income, domestic income, export price, and import price in order to show how exchange rate volatility affects imports and exports in the long run. Results showed that exchange rate volatility has negative effects on exports and imports. The empirical result is inconsistent with the theoretical relationship by Rose (2004, pg. 103), which has claimed that exports depend on risk diversion. Although an increase in income can have a positive effect in foreign or domestic trade, the real exchange rate causes depreciation of domestic currency and by extension an increase in export. However, IMF (2004, pg. 99) has argued that an increase in exchange rate volatility has a negative effect on imports and exports. On the other hand, Sercu & Uppal (2000, pg. 36) have investigated if there is evidence to prove the influence of exchange rate volatility on Swedish bilateral trade by using monthly data between 1995 and 2011. The research shows that exchange rate volatility has positive and negative effects based on nine countries. Exchange rate volatility and trade flow are determined by the composition index of propensity of risk. The empirical result shows that there was an increase in imports and exports between Switzerland and Germany. It must be mentioned that those countries have high levels of risk aversion compared to others. As a result, there is a simultaneous increase in trade flow and a higher of exchange rate volatility. The results are inconsistent with the theoretical relationship by IMF (2004, pg. 115) because higher exchange rate volatility results in a reduction in the volume of international trade. In the mean time, the empirical result shows that there is a decrease in imports and exports in four countries, including China, Japan, the Netherlands, and the United States. The countries have lower risk aversion levels in comparison with Germany. According to the results, there is a negative correlation in the trade flow and exchange rate volatility. In this case and according to Rose (2004, pg. 112) the empirical results make a concession that exchange rate depends on the risk aversion. In conclusion, this essay showed empirical evidence to judge the theoretical relationship between exchange rate volatility and international trade by using the experiment test. In this era, exchange rates fluctuate everyday and it is difficult to predict the trade flow. Since exchange rate volatility is hard to determine based on risk aversion, there are some special effects to impact the international transaction. These include policy and structural differences between countries. For example, Ortega & Giovanni (2005, pg. 22) shows that exchange rate volatility does not have a significant effect on import because Nigeria has high import content. Conversely, developed countries like China and Japan display a negative relationship between imports and exchange rate volatility. References Aizenman, J. 2002, Exchange rate flexibility, volatility, and the patterns of domestic and foreign direct investment, National Bureau of Economic Research, Cambridge, MA. International Monetary Fund, 2004, Exchange rate volatility and world trade: a study, International Monetary Fund, Washington, D.C. Ortega, C., & Giovanni, J. 2005, Trade costs and real exchange rate volatility the role of Ricardian comparative advantage, International Monetary Fund, Research Dept., Washington, D.C.: Rose, A. 2004, Exchange rate volatility, monetary policy, and capital mobility: empirical evidence on the holy trinity, National Bureau of Economic Research, Cambridge, MA. Sercu, P., & Uppal, R. 2000, Exchange rate volatility, trade and capital flows under alternative exchange rate regimes, Cambridge University Press, Cambridge, UK. Read More