Does third-country exchange rate affect bilateral trade? Public Deposited

http://ir.library.oregonstate.edu/concern/graduate_thesis_or_dissertations/cj82kb024

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  • 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.
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