Abstract:
As the real and nominal exchange rates have become more volatile since the
early 1970s, the study of the effect of exchange rate on trade flows has come into
sharp focus. While conventional effects of depreciation or appreciation of exchange
rates on trade flows have been accepted and verified by most economists, the impact
of exchange rate volatility remains unresolved. An important puzzle is the absence of
empirical support of the hypothesis that exchange rate volatility will have large and
negative effects on both bilateral and multilateral trade. However, these studies may
have ignored two relevant effects in the modeling and empirical applications: third-country
effects and the presence of forward currency markets.
This thesis identifies the exchange rate effects on bilateral trade while
accounting for third-country effects and forward currency markets. The theoretical
analysis suggests that in a bilateral trade model without a forward market, the
exchange rate volatility effect on trade flows is negative. However, with a fully
developed forward market, volatility of direct real exchange rate should have opposite
impacts on importers and exporters. Moreover, trade diversion could occur due to
changes in the level or volatility of the real exchange rate in a third currency.
The empirical analysis included 10 developed and 10 developing countries.
For the developed countries, quarterly data during the 1973 - 1998 period is used to
analyze the exchange rate effects on bilateral trade flows among them. For the
developing countries, their bilateral trade flows with 10 developed countries are
investigated. The results show evidence of third country exchange rate effects on the
bilateral trade flows, but they depend crucially on the relative levels and volatility of
direct and third-country real exchange rate.
