Conditional Exchange-Rate Volatility and the Volume of Foreign Trade: Evidence from Seven Industrialized Countries

Abstract

There has long been a concern over the volatility of exchange-rates and their impact on the volume of foreign trade.' However, very little attention has been paid to the choice of appropriate volatility variable as well as the proper specification of the trade equation. The sample standard deviation of the exchange rate has been used as a proxy for exchangerate uncertainty in empirical studies that examine the effects of exchange-rate uncertainty on the volume of foreign trade. See, for example, Akhtar and Hilton [1] and Gotur [27]. These studies have provided conflicting evidence on this issue. It has been argued that use of the sample standard deviation is inappropriate because the empirical distribution of exchange rates is not normal [22; 10]. In this regard, subsequent empirical research [12; 36; 40; 41; 11] has employed a moving standard deviation of the rate of change of the exchange rate as a proxy for exchange-rate uncertainty. Chowdhury [11] obtained a clear pattern of results that support the hypothesis that the higher volatility of exchange rates led to a reduction in international trade transactions after the breakdown of the Bretton Woods system in March 1973. Other studies have reported ambiguous results.2 The moving standard deviation used in these studies has been criticized in the literature for (a) ignoring relevant information on the random process generating exchange rates [18]; (b) underestimating the effect of volatility on decisions [52]; (c) distorting the measurement of the volatility variable by smoothing the series [9]; and (d) injecting an element of arbitrariness into the calculation through decisions about the order (m) of the moving average [43].3