Abstract
The paper examines the impact of exchange rate volatility on trade using an ARCH-in-mean model. The advantages of this statistical approach vis-a-vis earlier approaches is that it provides more efficient coefficient estimates and avoids the problem of spurious regressions.
Exchange rate volatility was found to have a negative impact on Canadian and Japanese exports to the United States and on Australian exports to the world. For Sweden, the United Kingdom and the Netherlands, the relationship was found to be positive. The magnitude of the impact of a 10% increase in exchange rate volatility on export volumes was found to range from a reduction of 7.4% (Canada) to an increase of 5% (Sweden).
The results indicate that exports invoiced in the importer's currency are affected negatively by exchange rate volatility, and exports invoiced in the exporter's currency are affected positively. A partial equilibrium, profit maximization model is derived to support these findings.
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The authors wish to thank Ron Duncan, George Tavlas, Michael Ulan, Ken Kroner, Stan Wellisz, Vikram Nehru and George Alogoskoufis for their valuable comments and suggestions.