Research

Abstract: Many past studies investigating the trade impact of exchange rate volatility have ignored one major reality: while the effect of exchange rate volatility on aggregate trade may be statistically insignificant, this result is likely driven by heterogeneity, as varied sectors of trade may respond differently to exchange rate shocks. Furthermore, the endogeneity of exchange rate volatility is well-documented in the literature but is not handled correctly. By using an instrumental variable approach that is new to this literature and disaggregating trade by end-use category, it is demonstrated that a one standard deviation increase in exchange rate volatility may lead to a  20-35 percent decrease in bilateral trade, depending on the end-use category specified. Such an increase in exchange rate volatility is associated with a number of currency crises faced by numerous economies in recent history.