Exchange Rate Volatility and Its Impact on Trade Flows

Introduction

The dissolution of the Bretton Woods system in 1973 introduced a new era for international markets. No longer would exchange rates be pegged, and the shift to floating rates changed the game for international trade and investment. The newly introduced volatility in foreign exchange markets increased the risk of uncertainty for all international transactions. Floating rates produce new complexities that have implications for any individual or organization that buys, sells, makes, or trades goods or currencies. These implications directly affect a nation's balance of trade, while also indirectly affecting the lives of individuals in one way or another.

Exchange rate volatility has produced mixed theories in academia regarding its effects on trade flows. McKenzie sparked considerable interest in the field when he published his findings in 1999. By conducting a meta-analysis, he found little statistically significant support for the claim that volatility affects overall trade volume. Since his work was published, many other scholars have produced studies with similar results, while others have found implications that tend, on the whole, to be market- and industry-specific.

The mixed results provided by these sources leave one continuing to speculate about the effects exchange rate volatility might have on trade flows. Some studies have produced evidence that when data is disaggregated to the industry level, significant effects from volatility become apparent, while other studies produce minimal evidence. However, though disaggregated market information provides more insightful views into specific markets and trade flows, the data in this area also produces mixed results.

The Bretton Woods System and Its Collapse

It is important to understand the historical context of the Bretton Woods system in order to fully appreciate the current academic debate. The Bretton Woods system was enacted after the end of the Second World War, when the United States emerged as the last remaining superpower. The U.S. leveraged its supremacy as the dominant world economy, maintained the gold standard, and offered other nations the confidence needed to peg their exchange rates to the dollar. Since the dollar was the strongest currency available after the war and U.S. production levels were comparatively high relative to other economies, the U.S. was able to achieve its position as the world's dominant currency.

The U.S. maintained this position into the early 1970s, when it faced increasing pressure from expanding European and Japanese economies to abandon fixed exchange rates. This pressure, combined with an inflationary period in the United States, led to a trade deficit and a consequent outflow of gold, making the system unstable. The Bretton Woods system was finally fully dismantled in February 1973.

Competing Theories on Trade Flow Effects

After Bretton Woods, floating exchange rates were thought by many to lead to a decrease in international trade activity (McKenzie, 1999). The increased risk stemming from exchange rate uncertainty was expected to result in reduced levels of trade. The assumption was that greater risk would diminish the incentive to engage in international trade. From the perspective of an individual considering such a transaction, increased risk would require a monetary premium, or the deal would simply not be beneficial. The required premium would shift the supply curve to the right, and consequently a reduced quantity of demand for the product would be realized by the producer. As an aggregate effect, this would decrease the volume of bilateral trade flows between countries.

However, an opposing theory also emerged. This theory held that increased exchange rate volatility would provide an incentive for firms to accelerate the velocity at which international transactions occurred (Hegerty, 2007). Under this view, volatility could act as a catalyst to increase the amount of trade. From the producer's perspective, if exporting were a cornerstone of the business model, producers would seek to minimize the effects of exchange rate volatility.

One method of achieving this would be to schedule transactions and currency conversions within the narrowest time frame possible. This heightened sense of urgency could then facilitate an increase in trade velocity and lead to an overall rise in trade volume — almost as if the floating exchange rate acted as a lubricant that accelerated the pace of trading mechanisms.

One study examined exchange rate volatility over an extended period, using monthly data from January 1974 to July 2000 to assess effects on imports in the UK (Cheong, 2004). The study found a statistically significant negative correlation between the risk associated with fluctuating exchange rates and import trade to the UK. This is significant because a substantial portion of the UK's trade involves other members of the European Union. Furthermore, the study suggested that if the UK were to adopt the euro, it could potentially benefit by mitigating this negative correlation through use of a single currency. However, this would only reduce risk on one front; the pound's volatility against other currencies, such as the dollar, would remain.

Conclusion

Since the dissolution of the Bretton Woods system, researchers have yet to pinpoint the precise effects of floating exchange rates on the global economy. Results of analysis tend to differ by the level of examination. When looking at specific industries within specific national economies, some evidence of significant effects may appear. In other cases, however, specific industries appear to absorb shocks entirely within themselves, as companies act on individualized strategies that produce a null effect at the industry-wide level.

Theoretically, it seems plausible that increased risk from floating exchange rates would cause risk-averse international traders to reduce overseas investment and redirect resources toward the domestic market. However, research on the topic has offered nothing conclusive to support this theory. As a result, economists and researchers have been working with increased fervor to solve this puzzle. Some countries have even entertained the idea of a new pegged system, sometimes called Bretton Woods II. Greece, amid its recent financial crisis, has certainly paid attention to such proposals.

When one considers what factors have changed since the dissolution of the Bretton Woods system, the emergence of new technologies stands out. New technologies have advanced both the speed of communication and the speed at which goods can be moved internationally. It may be the case that technology has played a role in diminishing the risks that would otherwise deter trade flows. Therefore, as future research continues to refine its approach to understanding the mixed results found in contemporary literature, technology may be one factor that provides further insight into why trade flows appear generally unaffected by exchange rate volatility.

Works Cited

Bahmani-Oskooee, M., & Kara, O. (2003). Relative responsiveness of trade flows to a change in prices and exchange rate. International Review of Applied Economics, 293–308.

Bahmani-Oskooee, M., & Wang, Y. (2008). Impact of exchange rate uncertainty on commodity trade between the U.S. and Australia. Australian Economic Papers, 235–258.

Cheong, C. (2004). Does the risk of exchange rate fluctuation really affect international trade flows between countries? Economics Bulletin, Vol. 6, No. 4, pp. 1–8.

Hegerty, M. B.-O. (2007). Exchange rate volatility and trade. Journal of Economic Studies, 34(3), 211–255.

McKenzie, M. D. (1999). The impact of exchange rate volatility on international trade flows. Journal of Economic Surveys, 13, 71–106.

Tokarick, S. (2008). Commodity currencies and the real exchange rate. Economics Letters, 60–62.