The effect of exchange rate volatility on trade: correcting for selection bias and asymmetric trade flows

Abstract

The gravity model that serves as an important framework to explore the relation between exchange rate volatility and international trade suffers from two weaknesses: selection bias caused by dropping of observations with zero trade flows and the inability to predict asymmetric bilateral trade flows. The latter includes situations of bilateral trade in one direction but not in the opposite direction. While some recent literature has addressed the selection bias, there are no studies that address both problems in the context of the effect of exchange rate volatility on international trade. The article contributes to the literature by applying a recent model of firm selection to control for both biases. We found that the effect of exchange rate volatility on trade, that appears to be weak under the standard gravity model or in those models that only correct for sample selection bias, emerges as a strong negative effect as both biases get controlled.