Exchange Rate Fluctuations and Trade Flows - Evidence from the European Union

WP/98/107-EAWP/98/107


Exchange Rate Fluctuations and Trade Flows:
Evidence from the European Union
Giovanni Dell'Ariccia


This paper analyzes the effects of exchange rate volatility on bilateral trade
flows. Evidence from panel data from the European Union shows that an increase
in exchange rate volatility depresses international trade. The results seem to
be robust with respect to the particular measures representing exchange rate
uncertainty. However, the absolute size of this effect appears to be very
small.


Particular attention is reserved for the problems of simultaneous causality
that usually arise in this kind of study. If central banks make an effort to
stabilize the exchange rate vis-à-vis their main commercial partners, a
negative correlation between volatility and trade will emerge from the data,
but it should not be construed to mean that trade flows react negatively to
exchange rate instability. In the paper this problem is addressed by using
instrumental variables and taking directly into account the central bank.s
behavior. If the relative size of each country.s commercial partners does not
change much over time, the central banks. stabilizing effort can be treated as
a country-specific fixed effect and eliminated by using a fixed-effect model.
The negative correlation between trade and bilateral volatility remains
significant after controlling for the simultaneity bias. However, a Hausman
test rejects the hypothesis of the absence of simultaneous causality.


The role played by the European exchange rate mechanism (ERM) in promoting
intre-EU trade is investigated. The ERM is found to have a not-significant, and
sometimes negative, effect on trade. This result can be attributed to the lack
of credibility of the official parities for most of the currencies and years in
the sample. Finally, some effort is made to address the magnitude of any
.trade-diverting. effect of a partial monetary union, but no strong conclusion
can be reached.