Does exchange rate volatility affect the impact of appreciation and depreciation on the trade balance? A nonlinear bivariate approach

Abstract

Does exchange rate volatility alter the effect of appreciation and depreciation on the trade balance? The literature posits that the trade balance responds more to depreciation shocks than appreciation shocks. Using monthly data from 1960M02–2020M12, we examine the asymmetric effects of exchange rates on the trade balance while accounting for exchange rate volatility. The study applies a nonlinear bivariate model that allows asymmetric effects and volatility to be examined concurrently. We find that exchange rate volatility reduces the positive effects of an appreciation shock on the trade balance in developed countries in the short and long run. In developing nations, exchange rate volatility promotes the positive effects of a depreciation shock on the trade balance, both in the short and long run. The transmission mechanism implies that a depreciation shock is ineffective in developed countries because the volatility that accompanies the shock diminishes the trade balance.