Exchange rate volatility and trade: a general equilibrium analysis

In this paper, we use insights from the literature on financial options to analyze the effect of exchange rate volatility on the volume of trade between countries. In contrast to existing work, this analysis is carried out in a model where the exchange rate is determined endogenously, and the volatility of the exchange rate depends on the volatility of the amounts available for consumption of the traded and non-traded goods. Our main result is to show that, in a one-good world, and contrary to the popular conjecture, an increase in exchange rate volatility is associated with an increase in the volume of trade. If a non-traded good is added, the above remains true when the source of exchange rate volatiliy is the uncertainty in the traded goods sector. However, when the source of exchange rate volatility is the non-traded goods sector then the volume of trade may decline. Thus, our model offers at least a partial explanation for the results of empirical studies that find only a weak relation between exchange rate volatility and trade. A policy implication of the model is that the volatility of the real exchange rate can be reduced, and welfare increased, in two ways: by reducing the volatility of fundamentals and by reducing the barriers to trade. However, while a reduction in trade barriers is associated with an increase in trade, a reduction in the volatility of fundamentals leads to a reduction in trade. Thus, more trade does not always mean a higher welfare.status: publishe