Exchange Rate Variability and the Level of International Trade

Abstract

There have been numerous theoretical and empirical studies of the effect of exchange rate variability on the level of international trade. Most theoretical studies have concluded that under reasonable assumptions exchange rate variability ought to depress the level of trade. Empirical studies generally have not identified a significant effect of exchange rate variability on trade flows. This paper builds a theoretical model in which exchange rate variability has a negative effect on the level of trade. The model is calibrated to observed trade flows and real exchange rates. Simulation of the model demonstrates that the effect of increasing exchange rate variability on trade flows is very small. These results are not sensitive to a wide range of parameter values. Moreover, reasonable extensions of the model only serve to minimize further the effect of exchange rate variability on trade flows.