The 34 reference contexts in paper Agathe Cote () “Exchange Rate Volatility and Trade: A Survey” / RePEc:bca:bocawp:94-5

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    Even though theory indicates that the effect of exchange rate volatility depends on the nature of the firm, the work is largely based on aggregate data. Evidence on the effect of exchange rate volatility on aggregate export volumes for industrial countries is mixed. The only recent studies that focus on Canadian trade flows are those of
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    Bélanger et al (1988, 1992).
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    They estimate regressions for Canada-U.S. trade flows for five broad sectors and conclude, in their latest paper, that they cannot find any significant effects of exchange rate risk. To summarize, our review of the most recent theoretical and empirical work does not allow one to draw any strong conclusion about the relationship between exchange rate volatility and trade.
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    It lowers the attractiveness of the risky activity, leading agents to reduce that activity (substitution effect). However, it also lowers the expected total utility of the activity, and to compensate for that drop, additional resources might be devoted to the activity (income effect). De
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    Grauwe (1988)
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    derives a model of a firm operating under perfectly competitive conditions that can allocate its production between domestic and foreign markets. The effect of an increase in exchange risk (a mean-preserving spread) will depend on the convexity properties of the utility function, which in turn depends on the degree of risk aversion.
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    Very risk-averse individuals worry about the worst possible outcome, and therefore, when risk increases, they may export more to avoid the possibility of a drastic decline in their revenues. As De
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    Grauwe (1988,
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    67) puts it, “although exporters are universally made unhappy by the volatility of exchange rates,... some may decide that they will be better off by exporting more.” De Grauwe emphasizes that the results obtained by Hooper and Kohlhagen follow from the restriction that is imposed on the utility function.
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    If the utility function is of the constant relative risk aversion family, an increase in risk decreases the volume of trade only if the coefficient of risk aversion is less than unity. One can note finally that
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    Giovannini (1988)
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    shows that even with risk neutrality, exchange rate volatility can affect the export pricing decision of a firm. We will return to this point in Section 2.3. 2.2.2 Hedging opportunities • The availability of forward cover reduces the effect of exchange rate volatility.
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    Several studies have examined how the presence of a forward exchange market affects the link between exchange rate volatility and trade. The earlier international trade models (for example,
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    Ethier 1973 and
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    Baron 1976a) conclude that with perfect forward markets and no other sources of uncertainty but the exchange rate, the volume of trade is unaffected by exchange rate volatility. The level of output only depends on the forward rate, while exchange rate volatility affects the hedging decision.
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    According to the authors, this result explains why several empirical studies cannot find significant coefficients on the volatility variable, since the trade balance can reverse sign over time. As well, 5. Theoretical analyses of optimal forward covering include
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    Ethier (1973),
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    Baron (1976a), Kawai and Zilcha (1986) and Eldor and Zilcha (1987). it is consistent with the finding of a positive effect in equations for U.S. exports to Japan, since Japan consistently ran surpluses with the U.
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    portfolio-diversification framework, even if the variability of the rate of return on a particular security is high, that security can still be attractive if it diversifies the portfolio as a whole. It has been argued that among the various risks incurred by a firm, exchange rate uncertainty may be relatively minor compared to the expected benefits of trade (see, for example,
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    McCulloch 1983).
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    Exchange risk is highly diversifiable and international operations may provide an important means of diluting risks associated with domestic transactions, rather than constitute an independent addition to risk.
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    If these assumptions are relaxed, changes in the exchange rate do not only represent a risk, they create opportunities to make profit. It is generally the case that price uncertainty may increase the average profits of the firm. De
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    Grauwe (1992)
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    presents the results for the simple case of a price-taking firm in a model without adjustment costs. When the price is high, the firm increases output to benefit from the higher revenue per unit. It gains a higher profit for the units it would have produced anyway and, in addition, it expands its output.
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    By so doing, it limits the reduction in its total profit. This positive effect on the utility of the firm has to be compared with the negative effects created by greater uncertainty for the risk-averse firm.
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    Gros (1987)
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    concentrates on the effect of exchange rate variability in the presence of adjustment costs. He derives a model of a competitive firm whose entire output is exported. Risk neutrality is assumed.
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    Increased volatility makes the option of entering and exiting the market more valuable, and therefore firms will adopt a wait-and-see attitude. A higher exchange risk means a higher probability that the exchange rate becomes more profitable in the future.
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    Dixit (1989)
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    shows that an increase in exchange rate volatility widens the hysteresis bands, implying that the industry becomes less responsive to exchange rate movements.6 Franke (1991) uses this framework to analyse the direct effects of exchange rate volatility on the export strategy of a firm in an intertemporal infinite horizon setting.
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    A higher exchange risk means a higher probability that the exchange rate becomes more profitable in the future. Dixit (1989) shows that an increase in exchange rate volatility widens the hysteresis bands, implying that the industry becomes less responsive to exchange rate movements.6
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    Franke (1991)
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    uses this framework to analyse the direct effects of exchange rate volatility on the export strategy of a firm in an intertemporal infinite horizon setting. The export strategy is associated with transaction costs.
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    The firm is more willing to sustain losses, and engage in dumping, before abandoning the market, a finding that appears consistent with the rise in antidumping cases filed over the world. 2.2.5 Trade composition A recent study by
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    Kumar (1992)
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    argues that exchange risk may decrease the net volume of trade but increase intraindustry trade. If exchange risk reduces net trade (which is calculated as the difference between gross trade and intraindustry trade), it must be resulting from a reduction in comparative advantage.
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    In the recent literature on exchange rate pass-through, three studies examine the role of uncertainty on export pricing decisions of a firm operating in a monopolistic competition framework.
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    Giovannini (1988)
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    shows that exchange rate uncertainty can affect expected profits and decisions of a risk-neutral exporter. This arises because producers have the ability to discriminate between home and foreign markets and to choose the currency of invoicing.
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    Price effects are always ambiguous, depending on the market structure, the currency denomination of contracts, and the availability of forward cover. Because microeconomic theory does not provide any clear-cut conclusions, some alternative assumptions have been offered. For example, it has been argued (De
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    Grauwe 1988)
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    that real exchange rate misalignments will generate a net increase in protectionist pressures and therefore negatively affect trade. The idea is that producers in the countries whose currencies become overvalued and see their profits squeezed will organize themselves to pass protectionist legislation and that this legislation will tend to stay in place when the currency la
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    There are issues concerning the measurement of the exchange rate itself: whether it should be bilateral or effective, real or nominal, and the appropriate way of measuring risk: short-run versus long-run horizon,ex ante versusex post, sustained deviations from trend versus period-to-period movements. 8. For a thorough discussion of the costs of a monetary union, see
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    Corden (1972).
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    The choice between bilateral and effective rates depends on whether one wishes to measure uncertainty facing the economy as a whole or that facing individual traders, and the degree to which traders are diversified.
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    As Bleaney puts it: “Misalignment does not necessarily entail volatility, and although volatility does entail some degree of misalignment, it may not be of sufficient magnitude or duration to be of real concern.”
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    (Bleaney 1992,
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    558) He therefore advocates the use of longer-run measures of volatility to better account for either persistence or mean-reversion of the exchange rate. The two measures of risk most commonly found in the empirical work are measures based on the standard deviation of the level or percentage change of the exchange rate, and measures based on the difference between the actual and f
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    use of standard deviation (or variance) to measure volatility is also subject to criticism, since the exchange rate has a skewed distribution (heavy tails).10 As well, the exchange rate seems to be characterized by “volatility clustering,” which means that successive price changes do not seem to be independent.11 Other methods of measuring volatility have therefore been proposed. For example,
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    Pozo (1992)
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    uses a GARCH model to compare real exchange rate volatility across 9. When using the real exchange rate, the choice of price index becomes an issue. 10. This means that the exchange rate has a greater proportion of large price changes than would a data set that is normally distributed. 11.
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    This means that the exchange rate has a greater proportion of large price changes than would a data set that is normally distributed. 11. Large changes tend to be followed by large changes while small changes are followed by small changes. See, for example,
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    Pozo (1992).
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    regimes over the 1900-40 period. He concludes that the average higher volatility depicted during flexible regimes is the result of an explosion of volatility at the start of the period. After that initial explosion, the level of uncertainty experienced during both regimes is similar.12 Measures based on ARCH or GARCH models have been used to test the effect of volatility on trade in some recent st
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    The studies we reviewed are listed in Table 1. In the recent papers, emphasis is placed on the appropriate measurement of risk and the estimation technique. The only studies focussing on Canada are those of
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    Bélanger et al. (1988, 1992).
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    In both studies, the authors examine the impact of nominal exchange rate volatility on Canada-U.S. trade flows in five sectors: food products, industrial supplies, capital goods, automotive vehicles and consumer goods.
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    More succinct reviews of the empirical literature can also be found in Edison and Melvin (1990) and Kumar and Whitt (1992). 14. In their second paper, they also construct a measure that isolates the risk premium in the forecast error using a method developed by
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    Pagan and Ullah (1988).
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    Table 1. Recent studies on exchange rate volatility and trade Study Data period and country quarterly 1975-86 U.S. quarterly 1976-87 Canada-U.S. annual 5 years (1973 to 1977) bilateral trade among 30 countries annual 1979-85 bilateral trade among 15 industrial countries monthly 1961-71 1975-85 U.
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    significant and negative in two sectors level of trade significantly higher in floating rate regime level of trade significantly stronger within EMS than outside EMS weak negative relationship few significant results insignificant for U.S. aggregate equation, often significant (negative) in other equations weak relationship significant and positive except for U.K. Bailey and Tavlas (1988)
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    Bélanger et al. (1988)
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    Brada and Méndez (1988) De Grauwe and Verfaille (1988) Koray and Lastrapes (1989) Mann (1989) Perée and Steinherr (1989) Lastrapes and Koray (1990) Asseery and Peel (1991) Table 1. Recent studies on exchange rate volatility and trade(continued) Bini-Smaghi (1991) quarterly 1976-84 W.
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    outside EMS weak negative relationship few significant results insignificant for U.S. aggregate equation, often significant (negative) in other equations weak relationship significant and positive except for U.K. Bailey and Tavlas (1988) Bélanger et al. (1988) Brada and Méndez (1988) De Grauwe and Verfaille (1988) Koray and Lastrapes (1989) Mann (1989) Perée and Steinherr (1989) Lastrapes and
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    Koray (1990) Asseery and Peel (1991)
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    Table 1. Recent studies on exchange rate volatility and trade(continued) Bini-Smaghi (1991) quarterly 1976-84 W.G., France, Italy intra-EMS trade quarterly 1975-88 U.S. bilateral imports quarterly 1975-87 Canada-U.
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    Bailey and Tavlas (1988) Bélanger et al. (1988) Brada and Méndez (1988) De Grauwe and Verfaille (1988) Koray and Lastrapes (1989) Mann (1989) Perée and Steinherr (1989) Lastrapes and Koray (1990) Asseery and Peel (1991) Table 1. Recent studies on exchange rate volatility and trade(continued)
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    Bini-Smaghi (1991)
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    quarterly 1976-84 W.G., France, Italy intra-EMS trade quarterly 1975-88 U.S. bilateral imports quarterly 1975-87 Canada-U.S. annual 1962-1987(88) U.S., W.G., Japan annual 1973-86 62 countries quarterly annual 1980,1985,1990 63 countries monthly 1973-89 (90) U.
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    significant and negative effects in volumes; mostly significant effects on prices significant negative for U.K. and W.G., insignificant for Japan not significant mixed results only unanticipated real exchange rate variability significant and negative not statistically significant small effect, negative in 1980, positive in 1990 significant, varied signs and magnitudes Feenstra and Kendall (1991)
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    Bélanger et al. (1992) Kumar (1992) Savvides (1992)
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    Gagnon (1993) Frankel and Wei (1993) Kroner and Lastrapes (1993) Despite the attention given to the estimation technique, the results of Bélanger et al. are not too convincing, since several of the explanatory variables do not have the expected signs.
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    Bailey and Tavlas (1988) report standard tests of the effect of volatility on aggregate U.S. export volumes over the 1975 to 1986 period. They examine the impact of short-term volatility as well as misalignment (based on the deviation between the current exchange rate and the equilibrium rate as computed by
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    Williamson 1985).
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    15 Both measures are insignificant. Perée and Steinherr (1989) focus on the problem of finding meaningful proxies for long-run exchange rate uncertainty. They construct two measures: the first one combines a proxy for uncertainty (based on the largest exchange rate movement over a 10-year horizon) and misalignment, the second one uses the integral of misalignment over the past period
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    the results to the fact that American exports are largely invoiced in U.S. dollars and that U.S. companies are more diversified, benefiting from a large domestic market that allows them more easily to compensate exchange rate uncertainty. The authors also report regression results for bilateral exports to the United States. Except for Japan, increased uncertainty appears to reduce trade volumes.
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    Asseery and Peel (1991)
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    also examine the influence of volatility on multilateral export volumes of five industrial countries. The novelty in their paper is the use of an error correction framework. It is argued that the non-robust results found in previous empirical work may be due to the fact that the export variable and some of its determinants are potentially non-stationary integr
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    Kroner and Lastrapes show that the results are not robust to using the conventional estimation strategy (estimating the export equation separately and substituting the GARCH measure by a six-month rolling sample variance). Koray and Lastrapes (1989) and Lastrapes and
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    Koray (1990)
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    use VAR models to examine the effect of exchange rate volatility on trade. The major advantage of this approach is that it does not impose exogeneity on the variables in the system. Exchange rate volatility may affect variables other than trade and, at the same time, it may be affected by some macro variables.
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    Gagnon notes, however, that these estimates are overstated, since the model ignores several features that would serve to minimize the effect of risk, such as inventories and futures markets, and that the degree of risk aversion that is assumed is almost certainly too large. In contrast to these papers,
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    Bini-Smaghi (1991)
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    finds strong support for the conventional assumption about volatility effects on trade. Bini-Smaghi focusses on trade in manufactured goods within the European Monetary System (EMS). Equations are estimated over the 1976 to 1984 period for export volumes and prices of Germany, France and Italy.
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    There are two reasons for the slower trade growth within the EMS: weaker income growth and a lower income elasticity of export demand, as the trade integration process levelled off. The authors note that the question remains as to whether low exchange rate variability is correlated with low growth of output. In a comment,
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    Melitz (1988)
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    holds that there are a number of serious shortcomings in their approach. In particular, he argues that their measure of volatility (based on consecutive monthly observations of annual changes) is insignificant, as it uses overlapping observations and therefore cannot measure annual volatility properly. 16.
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    Their preferred estimate suggests that a doubling of exchange rate volatility within Europe, as would happen if variability returned from its 1990 to its 1980 level, would reduce the volume of trade within the region by 0.7 per cent. Given that their results do not appear very robust, they conclude that the effect, if it is there at all, is small in magnitude.
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    Savvides (1992)
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    uses a two-step estimation method to test the assumption that only the unanticipated component of exchange rate volatility affects trade. Annual data for 62 industrial and developing countries are used to estimate regressions over the 1973 to 1986 period.
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    Although it is not mentioned in the text, the results for industrial countries are not too convincing, as the income and relative price terms are insignificant (the income term even has the wrong sign). The final study reviewed is that by
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    Kumar (1992),
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    who tests his assumption regarding the differential effect of volatility on intraindustry versus net trade. Equations are estimated for the United States, Japan and Germany. The results partly support Kumar’s assumptions.
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    Overall, a larger number of studies appear to favour the conventional assumption that exchange rate volatility depresses the level of trade (De Grauwe and Verfaille 1988, Koray and Lastrapes 1989, Perée and Steinherr 1989, BiniSmaghi 1991 and
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    Savvides 1992).
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    With the exception of De Grauwe and Verfaille, the magnitude of that effect would be rather small. On the other hand, Asseery and Peel (1991) and Kroner and Lastrapes (1993) find evidence of a positive effect of volatility on export volumes of some industrial countries (the two studies, however, get conflicting signs for the United Kingdom).
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    Overall, a larger number of studies appear to favour the conventional assumption that exchange rate volatility depresses the level of trade (De Grauwe and Verfaille 1988, Koray and Lastrapes 1989, Perée and Steinherr 1989, BiniSmaghi 1991 and Savvides 1992). With the exception of De Grauwe and Verfaille, the magnitude of that effect would be rather small. On the other hand,
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    Asseery and Peel (1991) and
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    Kroner and Lastrapes (1993) find evidence of a positive effect of volatility on export volumes of some industrial countries (the two studies, however, get conflicting signs for the United Kingdom).
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    than less, geographical concentration of industries.18 Therefore, a reduction in exchange rate volatility or, in the limiting case, the adoption of a common currency, would not necessarily lead to stronger inward investment. Although it is unlikely to produce more clear-cut results, it might be interesting to reexamine the evidence for Canada. 18. See, for example,
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    Krugman (1992).
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