The 30 reference contexts in paper Christopher F. Baum, Mustafa Caglayan (2006) “On the Sensitivity of the Volume and Volatility of Bilateral Trade Flows to Exchange Rate Uncertainty” / RePEc:boc:bocoec:641

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    The empirical results are, in general, sensitive to the choices of sample period, model specification, form of proxies for exchange rate volatility, and countries considered (developed versus developing).2 1Several theoretical studies (e.g.,
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    Clark (1973), Baron (1976))
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    have shown that an increase in exchange rate uncertainty will have adverse effects on the volume of international trade. Others, including Franke (1991), Sercu and Vanhulle (1992) have shown that exchange rate uncertainty may have a positive or ambiguous impact on the volume of international trade flows depending on aggregate exposure to currency risk (Viaene and de Vries (1992)) and the types of
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    results are, in general, sensitive to the choices of sample period, model specification, form of proxies for exchange rate volatility, and countries considered (developed versus developing).2 1Several theoretical studies (e.g., Clark (1973), Baron (1976)) have shown that an increase in exchange rate uncertainty will have adverse effects on the volume of international trade. Others, including
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    Franke (1991), Sercu and Vanhulle (1992)
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    have shown that exchange rate uncertainty may have a positive or ambiguous impact on the volume of international trade flows depending on aggregate exposure to currency risk (Viaene and de Vries (1992)) and the types of shocks to which the firms are exposed (Barkoulas, Baum and Caglayan (2002)).
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    Others, including Franke (1991), Sercu and Vanhulle (1992) have shown that exchange rate uncertainty may have a positive or ambiguous impact on the volume of international trade flows depending on aggregate exposure to currency risk (Viaene and de Vries (1992)) and the types of shocks to which the firms are exposed
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    (Barkoulas, Baum and Caglayan (2002)).
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    Also see models that study the impact of exchange rate uncertainty on trade and its welfare costs within a general equilibrium framework including Obstfeld and Rogoff (2003), Bacchetta and van Wincoop (2000). 2Negative effects of exchange rate uncertainty on trade flows are recently reported by Arize, Osang and Slottje (2000), Sauer and Bohara (2001) for developing countries, while Gagnon (1993) f
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    have a positive or ambiguous impact on the volume of international trade flows depending on aggregate exposure to currency risk (Viaene and de Vries (1992)) and the types of shocks to which the firms are exposed (Barkoulas, Baum and Caglayan (2002)). Also see models that study the impact of exchange rate uncertainty on trade and its welfare costs within a general equilibrium framework including
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    Obstfeld and Rogoff (2003),
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    Bacchetta and van Wincoop (2000). 2Negative effects of exchange rate uncertainty on trade flows are recently reported by Arize, Osang and Slottje (2000), Sauer and Bohara (2001) for developing countries, while Gagnon (1993) finds insignificant effects for developed countries.
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    Also see models that study the impact of exchange rate uncertainty on trade and its welfare costs within a general equilibrium framework including Obstfeld and Rogoff (2003), Bacchetta and van Wincoop (2000). 2Negative effects of exchange rate uncertainty on trade flows are recently reported by
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    Arize, Osang and Slottje (2000), Sauer and Bohara (2001)
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    for developing countries, while Gagnon (1993) finds insignificant effects for developed countries. Baum, Caglayan and Ozkan (2004) report that the impact of exchange rate volatility on export flows differs in sign and magnitude across the countries studied.
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    Also see models that study the impact of exchange rate uncertainty on trade and its welfare costs within a general equilibrium framework including Obstfeld and Rogoff (2003), Bacchetta and van Wincoop (2000). 2Negative effects of exchange rate uncertainty on trade flows are recently reported by Arize, Osang and Slottje (2000), Sauer and Bohara (2001) for developing countries, while
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    Gagnon (1993)
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    finds insignificant effects for developed countries. Baum, Caglayan and Ozkan (2004) report that the impact of exchange rate volatility on export flows differs in sign and magnitude across the countries studied.
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    uncertainty on trade and its welfare costs within a general equilibrium framework including Obstfeld and Rogoff (2003), Bacchetta and van Wincoop (2000). 2Negative effects of exchange rate uncertainty on trade flows are recently reported by Arize, Osang and Slottje (2000), Sauer and Bohara (2001) for developing countries, while Gagnon (1993) finds insignificant effects for developed countries.
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    Baum, Caglayan and Ozkan (2004)
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    report that the impact of exchange rate volatility on export flows differs in sign and magnitude across the countries studied. We should also note that researchers implementinggravity models (see Frankel and Wei (1993), Dell’Ariccia (1999), Rose (2000), and Tenreyro (2003) among others) have generally found a 2 More recently Baum et al. (2004) rely on a nonlinear specification rather than linear a
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    Baum, Caglayan and Ozkan (2004) report that the impact of exchange rate volatility on export flows differs in sign and magnitude across the countries studied. We should also note that researchers implementinggravity models (see
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    Frankel and Wei (1993),
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    Dell’Ariccia (1999), Rose (2000), and Tenreyro (2003) among others) have generally found a 2 More recently Baum et al. (2004) rely on a nonlinear specification rather than linear alternatives while integrating the role of foreign income uncertainty in evaluating the impact of exchange rate uncertainty on bilateral trade flowsbetween several developed countries.
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    Baum, Caglayan and Ozkan (2004) report that the impact of exchange rate volatility on export flows differs in sign and magnitude across the countries studied. We should also note that researchers implementinggravity models (see Frankel and Wei (1993), Dell’Ariccia (1999),
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    Rose (2000), and Tenreyro (2003)
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    among others) have generally found a 2 More recently Baum et al. (2004) rely on a nonlinear specification rather than linear alternatives while integrating the role of foreign income uncertainty in evaluating the impact of exchange rate uncertainty on bilateral trade flowsbetween several developed countries.
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    Baum, Caglayan and Ozkan (2004) report that the impact of exchange rate volatility on export flows differs in sign and magnitude across the countries studied. We should also note that researchers implementinggravity models (see Frankel and Wei (1993), Dell’Ariccia (1999), Rose (2000), and Tenreyro (2003) among others) have generally found a 2 More recently
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    Baum et al. (2004)
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    rely on a nonlinear specification rather than linear alternatives while integrating the role of foreign income uncertainty in evaluating the impact of exchange rate uncertainty on bilateral trade flowsbetween several developed countries.
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    (2000), and Tenreyro (2003) among others) have generally found a 2 More recently Baum et al. (2004) rely on a nonlinear specification rather than linear alternatives while integrating the role of foreign income uncertainty in evaluating the impact of exchange rate uncertainty on bilateral trade flowsbetween several developed countries. Although their findings are mixed, a subsequent analysis by
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    Grier and Smallwood (2007)
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    using a group of developed and developing countries finds a significant role in developing countries’ exports for exchange rate uncertainty as well as a strong role for income uncertainty in most countries.3 In this paper, we present two sets of empirical findings motivated by the theoretical propositions of Barkoulas et al. (2002) that (i) exchange rate uncertainty affects the volume of trade flo
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    Although their findings are mixed, a subsequent analysis by Grier and Smallwood (2007) using a group of developed and developing countries finds a significant role in developing countries’ exports for exchange rate uncertainty as well as a strong role for income uncertainty in most countries.3 In this paper, we present two sets of empirical findings motivated by the theoretical propositions of
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    Barkoulas et al. (2002)
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    that (i) exchange rate uncertainty affects the volume of trade flows and (ii) exchange rate uncertainty affects the variability of trade flows. Researchers generally motivate the first hypothesis indicating that exchange rate uncertainty will inevitably depress the volume of international trade by increasing the riskiness of trading activity.
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    , Wei, Sadikov and Zeng (2004) indicate that ‘this negative relationship, however, is not robust to a more general specification of the equation linking bilateral trade to its determinants that embodies the recent theoretical advances in a gravity model’ (p. 2). 3One would be tempted to think that the exposure to unforeseenmovements in exchange rates can be avoided using hedging. However,
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    Wei (1999)
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    finds no empirical support for the hypothesis that the availability of hedging instruments reduces the impact of exchange rate volatility on trade. 4For instance, according to Barkoulas et al. (2002), in open economies where the importance of international trade is sizable, variability of trade flows can significantly impact the variability of the overall level of economic activity resulting in ‘f
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    that embodies the recent theoretical advances in a gravity model’ (p. 2). 3One would be tempted to think that the exposure to unforeseenmovements in exchange rates can be avoided using hedging. However, Wei (1999) finds no empirical support for the hypothesis that the availability of hedging instruments reduces the impact of exchange rate volatility on trade. 4For instance, according to
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    Barkoulas et al. (2002),
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    in open economies where the importance of international trade is sizable, variability of trade flows can significantly impact the variability of the overall level of economic activity resulting in ‘financial sector illiquidity, reductions in real output, and/or heightened inflationary pressures’ (p. 491). 3 volatility is often several times that of aggregate output,as recognized by Engel and Wang
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    al. (2002), in open economies where the importance of international trade is sizable, variability of trade flows can significantly impact the variability of the overall level of economic activity resulting in ‘financial sector illiquidity, reductions in real output, and/or heightened inflationary pressures’ (p. 491). 3 volatility is often several times that of aggregate output,as recognized by
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    Engel and Wang (2007) and Zimmermann (1999).
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    Hence, we consider the effects of exchange rate uncertainty on the volatility of trade flows as animportant factor in the predictability of aggregate economic activity. Our investigation concentrates on bilateral trade flows between 13 countries including the US, UK, Canada, Germany, France, Italy, Japan, Finland, Netherlands, Norway, Spain, Sweden, and Switzerland for the period 1980–1998 on a mo
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    This observation should not be too surprising as the recent empirical literature has recorded similar findings. Furthermore, these results are in line with the theoretical literature. Our second set of findings is new and novel as we provide indirect empirical support to a proposition suggested in
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    Barkoulas et al. (2002).
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    Specifically, we show that exchange rate uncertainty has a meaningful empirical impact on the volatilityof trade flows. We find that 81 out of 143 models tested provide support for a statistically significant steady-state effect of exchange rate uncertainty on trade volatility.
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    and draws implications for future theoretical and empirical research. 2 Motivation There is a long list of papers which focus on the effects of exchange rate variability on trade flows6arguing that exchange rate uncertainty will inevitably depress the volume of international trade by increasing the riskiness of trading activity. Our twopronged empirical investigation is mainly motivated by
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    Barkoulas et al. (2002)
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    who utilize a partial equilibrium model to study the impact of exchange rate movements on the level and volatility of trade flows. They claim that an analysis considering the effects of exchange rate uncertainty only on the volume of trade will not be capable of generating predictions of managers’ optimal behavior.
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    Notably, few researchers have considered the second hypothesis despite the fact that the volatility of trade flows relative to that of aggregate output is sizable: often a factor of two or threetimes GDP volatility, and as volatile as investment spending. The model that
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    Barkoulas et al. (2002)
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    construct assumes that managers’ decisions to export (or import) depend upon both expected returnand risk and suggests 6See notes 1 and 2 above. 5 modeling the impact of exchange rate uncertainty on both thefirst and second moments of trade flows.
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    Although our hypothesis that uncertaintyin trade flows arising from exchange rate uncertainty will have serious effects on the macroeconomy is different from those studies’ emphasis, it would be useful to documentsome of the findings reported in them. In a recent contribution considering trade flow volatility,
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    Engel and Wang (2007)
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    lay out a two-country two-sector model to understand international real business cycles. They state that although countercyclical behavior of net exports is a well established fact, the literature has neglected thebehavior of imports and exports which tend to be much more volatile than GDP.
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    goods to explain the volatility of trade flows assuming that while switching between home and foreign durable goods is highly costly in the short run, home and foreign goods are perfect substitutes in the long run. Their simulation results are generally supportive as their model captures the volatility of trade flows along with several other features of the data. The second study is that of
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    Zimmermann (1999).
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    He, too, provides an international real business cycle model to explain the behavior of components of GDP and attempts to rationalize trade flow variability. He points out that trade flows are much more volatile than GDP—as volatile as investment—and that prior research has not addressed this issue.
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    In our empirical investigation below, we employ a simple reduced form model to understand how movements in real exchange rates affect thebehavior of (i) the level and (ii) the volatility of exports. Although our studycan best be described in the spirit of
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    Barkoulas et al. (2002),
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    we do not attempt to capture exchange rate 7Using a model in the spirit of Zimmermann (1999), Engel and Wang show that an increase in exchange rate volatility can be helpful in explaining the volatility in trade flows.
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    In our empirical investigation below, we employ a simple reduced form model to understand how movements in real exchange rates affect thebehavior of (i) the level and (ii) the volatility of exports. Although our studycan best be described in the spirit of Barkoulas et al. (2002), we do not attempt to capture exchange rate 7Using a model in the spirit of
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    Zimmermann (1999),
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    Engel and Wang show that an increase in exchange rate volatility can be helpful in explaining the volatility in trade flows. But their construct yields a negative correlation between the levels of exportsand imports, whereas that correlation is generally positive in the data. 7 uncertainty that may arise from different sources.
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    To match the monthly frequency of export data, we must generate a proxy for monthly foreignGDPas the available data is on a quarterly basis.8Hence, we apply the proportional Denton benchmarking technique
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    (Bloem, Dippelsman and Maehle (2001)) to
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    the quarterly realGDPseries in order to produce monthlyGDPestimates. The proportional Denton benchmarking technique uses the higher-frequency movements of an associated variable—in our case monthly industrial production—as an interpolator within the quarter, while enforcing the constraint that the sum of monthlyGDPflows equals the observed quarterly total.
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    Equation (2) definesthe conditional mean of the ∆ log real exchange rate (st) as a function of its own lag and ∆ lagged trade volume as well as a first-order moving average innovation. The vector of innovations is defined asut= [ωt,ηt]′. The diagonal elements ofHtare the conditional variances of ∆ log real exchange rate,σ2xtand ∆ log trade volume,σ2strespectively. Following
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    Karolyi (1995),
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    the matrixCis parameterized as lower triangular while matricesAandBare 2×2 matrices, so that there are eleven estimated parameters in equation (3). We assume that the errors are jointly conditionally normal with zero means and conditional variances given by anARMA(1,1)structure as expressed in 10 equation (3).
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    Given the monthly frequency of the data and the large number of coefficients on highly correlated regressors to be estimated, we did not find that an unconstrained distributed lag approach produced usable nor dynamically stable estimates. 12Althoughβ1is the coefficient of a generated regressor
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    (Pagan, 1984; Pagan, 1986),
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    inference on the existence of a significantβ1coefficient is not hindered by that issue. 13We note thatσ2 stis a generated regressor, as is the dependent variable in this equation, which is an augmented autoregression.
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    4.1 Timeseries properties of the data In the literature, it has commonly been assumed that trade volume series (real exports) and real exchange rates, in level or log form, are nonstationary (I(1)) processes given evidence from univariate unit root tests. Prior to estimating our system of equations, we test each series for a unit root using the modified log-periodogram regression test of
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    Phillips (2007)
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    as implemented in Baum and Wiggins (2001). We find that the overwhelming proportion of both log exchange rate and log trade flow series exhibitI(1) characteristics while the logGDPseries areI(1) except for four instances.
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    of the data In the literature, it has commonly been assumed that trade volume series (real exports) and real exchange rates, in level or log form, are nonstationary (I(1)) processes given evidence from univariate unit root tests. Prior to estimating our system of equations, we test each series for a unit root using the modified log-periodogram regression test of Phillips (2007) as implemented in
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    Baum and Wiggins (2001).
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    We find that the overwhelming proportion of both log exchange rate and log trade flow series exhibitI(1) characteristics while the logGDPseries areI(1) except for four instances. For the remainder of our analysis we keep those series that are clearly classified asI(1) and drop the remaining series.
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    relationship in only six models.20The greatest number of significant effects (10) is registered by Spain, allpositive, followed by the USand Switzerland (eight each, with seven positive for each country). Given that the overwhelming majority of the models provide a positive relationship between exchange rate uncertainty and the volatility of trade flows,considering our findings in the light of
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    Barkoulas et al. (2002),
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    we conjecture that either the preponderance of 20At the ten per cent level of significance, we find 90 nonzero coefficients: 82 positive, eight negative. 17 shocks to the exchange rate process are associated with shocks to the fundamentals or that fundamental shocks are larger or have a greater impact on the real exchange rate than other shocks.21 The impact of a one standard deviation increase in
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    However the complexity of our methodology leads us to leave this issue for future investigation. 18 employing a bivariateGARCHmethodology. Using these proxies, we investigate the impact of exchange rate volatility on the mean and the variance of trade flows in the spirit of
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    Barkoulas et al. (2002).
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    Our first set of resultssuggest that the impact of exchange rate volatility on trade flows is indeterminate.Only a small number of models (30 out of 143) present significant relationships: significant and positive in 23 models and significantly negative in the remaining seven models.
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    Our second set of findings is new and novel as we investigate the relationship between exchange rate volatility and that of trade flows. We first show that bilateral trade volatility is higher than GDP volatility, a stylized fact earlier documented by
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    Engel and Wang (2007) and Zimmermann (1999)
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    for aggregate trade flows. We then run a simple dynamic model to see if exchange rate volatilityleads to higher trade variability. We find that for 81 out of 143 potential models, exchange rate volatility exhibits a positive steady-state impact on the volatility of trade flows.
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