Exchange rate volatility and international trade: a general equilibrium analysis

Sercu, P and Uppal, R (2003) Exchange rate volatility and international trade: a general equilibrium analysis. Working Paper. London Business School IFA Working Paper.

Abstract

In this paper, we use insights from the literature on ficial options to analyze the effect of exchange rate volatility on the volume of trade between countries. In contrast to exisitng work, this analysis is carried out in a generalequilibrium stochasticendowment economy with imperfect international commodity markets in which both trade and exchange rate volatility are endogenous quantities. Our main objective is to examine the popular conjecture that an increase in exchange rate volatility is associated with a decrease in the volume of international trade. We show that, even in a simple model, the relation between trade volume and exchange rate volatlity can be either negative or positive depending on the underlying source for the change in exchange rate volatility. Specifically, when the source of the increase in exchange rate volatility is an increase in the volatility of the endowment processes, our model predicts an increase in the expected volume of trade. On the other hand, when there is an increase in the segmentation of commodity markets, exchange rate volatility increases but the volume of trade decreases. In both cases there is a drop in welfare, but in the first case this is associated with an increase in trade and in the second case with a decrease in trade.