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This volatility has
often been cited by the proponents of managed or fixed exchange rates as
detrimental, since in their view exchange rate uncertainty will inevitably depress
the volume of international trade by increasing the riskiness of trading activity.1
Several theoretical studies (e.g.
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Ethier (1973), Clark (1973), Baron (1976), Cushman (1986), Peree and Steinherr (1989))
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have shown that an increase in exchange rate
volatility will have adverse effects on the volume of international trade. Other
theoretical studies have demonstrated that increased volatility can have ambiguous
or positive effects on trade volume: for instance, Viaene and de Vries (1992), who
explicitly model the forward market, and Franke (1991)
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Other
theoretical studies have demonstrated that increased volatility can have ambiguous
or positive effects on trade volume: for instance, Viaene and de Vries (1992), who
explicitly model the forward market, and
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Franke (1991) and Sercu and Vanhulle (1992),
 Suffix

who consider exporting as an option to a multinational firm facing entry–exit
costs in the foreign market.
Given these contradictory theoretical predictions, empirical researchers have
examined the effect of both real and nominal exchange rate volatility on the
volume of international trade.
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of flexible exchange rates, neither importers nor exporters
have perfect information regarding the behavior of future exchange rates, since
those rates are subjected to a number of shocks. However, making use of all
2 Negative effects of exchange rate uncertainty on trade flows are reported by
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Cushman (1983, 1986, 1988), Akhtar and Hilton (1984), Thursby and Thursby (1987), Kenen and Rodrik (1986), and Peree and Steinherr (1989),
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among others, while Hooper and Kohlhagen (1978), Gotur (1985), Koray and
Lastrapes (1989), and Gagnon (1993) find insignificant effects. Kroner and Lastrapes (1993), using a
multivariate GARCHinmean model, report that the reducedform effects of volatility on export
volume and prices vary widely.
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However, making use of all
2 Negative effects of exchange rate uncertainty on trade flows are reported by Cushman (1983, 1986, 1988), Akhtar and Hilton (1984), Thursby and Thursby (1987), Kenen and Rodrik (1986), and Peree and Steinherr (1989), among others, while
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Hooper and Kohlhagen (1978), Gotur (1985), Koray and Lastrapes (1989), and Gagnon (1993)
 Suffix

find insignificant effects. Kroner and Lastrapes (1993), using a
multivariate GARCHinmean model, report that the reducedform effects of volatility on export
volume and prices vary widely.
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Negative effects of exchange rate uncertainty on trade flows are reported by Cushman (1983, 1986, 1988), Akhtar and Hilton (1984), Thursby and Thursby (1987), Kenen and Rodrik (1986), and Peree and Steinherr (1989), among others, while Hooper and Kohlhagen (1978), Gotur (1985), Koray and Lastrapes (1989), and Gagnon (1993) find insignificant effects.
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Kroner and Lastrapes (1993),
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using a
multivariate GARCHinmean model, report that the reducedform effects of volatility on export
volume and prices vary widely. The estimated effects of GARCH conditional variance of the nominal
exchange rate on export flows differ in sign and magnitude across the countries studied.
3 For a survey of theoretical arguments and empirical findings on the relationsh
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The estimated effects of GARCH conditional variance of the nominal
exchange rate on export flows differ in sign and magnitude across the countries studied.
3 For a survey of theoretical arguments and empirical findings on the relationship between exchange
rate volatility and trade flows, see
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Farell et al. (1983),
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IMF (1984), Willett (1986) regarding t h e
literature through the mid1980s, and Côté (1994) for more recent works.
4 It should be noted that, in almost all cases, the impact of exchange rate volatility on trade flows h a s
been investigated using aggregated data.
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The estimated effects of GARCH conditional variance of the nominal
exchange rate on export flows differ in sign and magnitude across the countries studied.
3 For a survey of theoretical arguments and empirical findings on the relationship between exchange
rate volatility and trade flows, see Farell et al. (1983), IMF (1984),
 Exact

Willett (1986)
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regarding t h e
literature through the mid1980s, and Côté (1994) for more recent works.
4 It should be noted that, in almost all cases, the impact of exchange rate volatility on trade flows h a s
been investigated using aggregated data.
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can indirectly influence the volume of trade through its effects on the forward rate.
6 Some researchers have proposed that the use of hedging instruments could possibly eliminate t h e
effects of exchange rate uncertainty on trade. However, there are wellknown limitations and costs
associated with the usage of currency derivatives. In a recent empirical study,
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Wei (1999)
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shows that
the availability of hedging instruments cannot explain the observed inconsistent relationship between
exchange rate volatility and trade flows.
The first two components of the process in (1) are driven by the fundamental
factors determining exchange rate behavior.
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which is
not observable by either the monetary authorities or the public and is modeled as a
white noise process, ησηtN~,02().8 We generically refer to a shock as a general
microstructure shock if it represents innovations to the exchange rate process
arising from the effects of portfolio shifts among international investors (following
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Evans and Lyons (1999)),
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excess speculation, bubbles and rumors, bandwagon effects,
or the effects of technical trading by chartists or “noise traders”.9 Such shocks are
generally shortterm in nature and represent temporary excursions from the
fundamental value of the exchange rate.
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Monetary
policy has a significant impact on the behavior of these fundamental factors.
8 Although it is possible to introduce highfrequency, meanreverting components in modeling η
t, doing
so would complicate the analysis without affecting any of the subsequent results.
9
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Taylor and Allen (1992) and Cheung and Chinn (1999)
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report that foreign exchange dealers rely on
technical analysis to form shortterm exchange rate predictions, which tend to be selffulfilling.
underlying economic fundamentals. We assume that the νt and tη processes are
independent.
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The decomposition of the exchange rate process in (1) and its functional form
assumptions are consistent at both theoretical and empirical levels. Theoretically,
the proposed modeling of the exchange rate process is consistent with the chartistandfundamentalist approach suggested by
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Frankel and Froot (1988) and
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empirically
tested by Vigfusson (1996). It is also broadly consistent with the permanenttransitory component decomposition drawn from Mussa's (1982) stochastic
generalization of the Dornbusch (1976) exchangerate overshooting model.
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Theoretically,
the proposed modeling of the exchange rate process is consistent with the chartistandfundamentalist approach suggested by Frankel and Froot (1988) and empirically
tested by
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Vigfusson (1996).
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It is also broadly consistent with the permanenttransitory component decomposition drawn from Mussa's (1982) stochastic
generalization of the Dornbusch (1976) exchangerate overshooting model.
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,
the proposed modeling of the exchange rate process is consistent with the chartistandfundamentalist approach suggested by Frankel and Froot (1988) and empirically
tested by Vigfusson (1996). It is also broadly consistent with the permanenttransitory component decomposition drawn from Mussa's (1982) stochastic
generalization of the
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Dornbusch (1976)
 Suffix

exchangerate overshooting model.
Empirically, Mark (1995), Chinn and Meese (1995), and Mark and Sul (1999) show
that longhorizon exchange rate movements are determined by economic
fundamentals such as relative money stocks and relative real incomes: stochastic
processes that are quite persistent.
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It is also broadly consistent with the permanenttransitory component decomposition drawn from Mussa's (1982) stochastic
generalization of the Dornbusch (1976) exchangerate overshooting model.
Empirically,
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Mark (1995), Chinn and Meese (1995), and Mark and Sul (1999)
 Suffix

show
that longhorizon exchange rate movements are determined by economic
fundamentals such as relative money stocks and relative real incomes: stochastic
processes that are quite persistent.
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conveys the idea that the higher is the
information content of the signal (the lower is σψ2), the more weight agents will
place on the signal St as ∂λ
∂σψ2
<0
in order to predict νt and therefore t ̃e.
10 Central bank intervention in the foreign exchange market may signal future monetary policy
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(Kaminsky and Lewis (1996)).
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11 This simple application of linear regression allows an agent in an uncertain environment to predict an
"unobserved variable in a manner that is optimal, in a certain sense." (Sargent (1987), p. 223)
2.2.
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to predict νt and therefore t ̃e.
10 Central bank intervention in the foreign exchange market may signal future monetary policy
(Kaminsky and Lewis (1996)). 11 This simple application of linear regression allows an agent in an uncertain environment to predict an
"unobserved variable in a manner that is optimal, in a certain sense."
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(Sargent (1987),
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p. 223)
2.2. The Behavior of Importers
The importer faces a nonstochastic inverse linear demand function
PY()=a−
Y
2
, where a>0 and P and Y denote the price and volume (quantity) of
imports, respectively.12 Assuming that the nominal price of the imported
commodity is one unit of foreign currency, the cost of imports in terms
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trading volume of importers and exporters and
the trade balance are obtained by differentiating equations (7), (12), and (13) with respect to e,
yielding
−= =
++()
>
∂
∂
∂
∂γσλ σψη
Y
e
X
e
1
1
220
and ∂
∂γσλ σψη
TB
e
mn
=
+
++()
>
1
220.
The obtained results are intuitive and consistent with those in the literature (see Viaene and
de Vries (1992) and
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Franke (1991)
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for example). A currency appreciation (depreciation) increases
(decreases) the expected profits of importers (exporters), thus resulting in an increase (decrease) in
imports (exports) volume and therefore a decrease (increase) in the trade balance.
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rate uncertainty does matter in determining
19 In a model of firms who may choose to enter or exit foreign markets, a "real options" framework h a s
been utilized to demonstrate that increased volatility enhances the value of the option to enter (exit)
the market, and causes firms to adopt a "wait and see" attitude.
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Dixit (1989)
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shows that this causes
firms to become less responsive to exchange rate movements.
its ultimate effect on the behavior of trade flows, empirical researchers should
attempt to estimate the components of exchange rate uncertainty and evaluate their
specific effects on trade volume and trade volatility.
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