WORLD TRADE  
ORGANIZATION   
WT/WGTDF/W/57 
27 September 2011 
 (11-4673) 
Working Group on Trade, Debt 
and Finance  
 
 
THE RELATIONSHIP BETWEEN EXCHANGE  RATES AND INTERNATIONAL TRADE: 
 
A REVIEW OF ECONOMIC LITERATURE 
 
Note by the Secretariat 
 
  
 
 
 
 
I. INTRODUCTION 
1. At the 22
nd meeting of the WTO Working Group on Trade, Debt and Finance (WGTDF), held 
on May 10, 2011, WTO Members reached a consensus on proceeding with the implementation of "pillar one" of Brazil's proposal set out in WTO Document WT/WGTDF/W/53, starting with the 
following activity:  
"Request(ing) the Secretariat to prepare an updated review of available literature and 
research (on the relationship between exchange rat es and international trade), particularly in 
the light of the crisis that started in 2008. The Secretariat should consult Members on any literature that they may wish to indicate."  
2. This Note has been prepared in  response to that request.  At the meeting of May 10, 2011, 
Members offered suggestions on how to proceed.
1 First, some Members suggested that the review 
should build on the 2004 paper by the International Monetary Fund on the effects of exchange rate 
volatility on trade, itself prepared in response to a request from the then Dir ector-General of the WTO 
and from the Working Group at the time.2 Other Members suggested that certain WGTDF observers 
would be particularly well positioned to provide  a view, in addition to the Members' own 
contributions, and any literature that could be r ecommended to the Secretariat. The observers in 
question are the International Monetary Fund (IMF) , the World Bank, the Organization for Economic 
Co-operation and Development (OECD) and th e United Nations Conference for Trade and 
Development (UNCTAD).  
3. Members have drawn the attention of the Secretariat to a large number of studies. All in all, 
some 30 papers, references, and summaries of papers , have been indicated to the Secretariat. These 
studies cover a rather wide spectrum of issues linke d to the relationship between exchange rates and 
trade, albeit not all of them on the strict relations hip between the two. The Secretariat reviewed some 
of them in Section II, which focuses on the direct (and rather narrow) relationship between exchange rates and international trade, in particular the em pirical papers that complement the large body of 
studies measuring that relationship. Other papers submitted by Members are included in Section III.   
                                                      
1 Document WT/WGTDF/M/22. 
2 IMF (2004), Exchange Rate Volatility and Trade Flows - Some New Evidences, Washington D.C., 
circulated in the WTO as Document WT/WGTDF/W/24. This document has been prepa red under the Secretariat's own 
responsibility and without prejudice to the positions of Members 
and to their rights and obligations under the WTO WT/WGTDF/W/57 
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4. The distribution of Members' papers between  Sections II and III should not be seen as a 
selection based on relevancy or academ ic quality. In designing Section II, the Secretariat had in mind 
the balance of positions expressed in the meeting of  the Working Group on Trade, Debt and Finance 
on May 10, 2011. For example several Members have accepted the principle of an examination of the 
relationship between exchange rate and trade provide d that "due consideration be taken of the work 
conducted in other fora" and that it did not "cro ss the borders of the respective competencies of 
international institutions".
3  
5. It turns out that important aspects of the literatu re on exchange rates that may have a bearing 
on trade are already discussed under other internati onal processes by the institution responsible for the 
surveillance of exchange rate policies, namely the IMF.4 These include the factors behind the 
determination of exchange rates, the issue of the optimal choice per se of exchange rate arrangements 
or regimes (e.g. fixed versus floating), the impact  of different exchange rate regimes, and the 
relationship between exchange rate policies and globa l imbalances.  Members' papers falling into this 
category have been described in Section III. The S ecretariat is aware that any such a distinction 
between categories can be somewhat subjective, a nd it should not be seen to confer any status or 
preference in respect of the papers concerned, nor  should it prejudge their relevance for the Members' 
discussion.   
II. AN OVERVIEW OF THE LITERATURE 
A. THE "EARLY " LITERATURE (UP TO THE 2004  IMF STUDY ): TESTING THE DIRECT EFFECT OF 
EXCHANGE RATE UNCERTAINTY  
1. Direct links versus indirect links 
6. Sub-section A focuses on the direct links between ex change rates and trade, in particular the 
heavily debated question as to whether exchange rate uncertainty reduces the incentives to trade 
internationally. This particular question appeared to be a prime focus of academic interest when 
exchange rate volatility increased after the end of the gold exchange standard (IMF, 1984). The 
Secretariat is providing a review of both the "early " (1973-late 1990's) and "recent" literature (2000's), 
the latter being only relevant in the light of the earlier.    
7. Policy-makers have always been attentive to th e effects of exchange rate misalignments, not 
the least because the IMF precl udes competitive devaluations.5 The issue gained greater prominence 
in the economic debate from the 1990s onwards, when  sustained deviations of exchange rates from 
their equilibrium values were suspected, rightly or  wrongly, to be at the origin of global current 
account imbalances. From a macroeconomic point of view, exchange changes can have strong effects 
on the economy, as they may affect the structure of output and investment, lead to inefficient 
allocation of domestic absorption and external trad e, influence labour market and prices, and alter 
external accounts. Hence, exchange rate shifts affe ct international trade both in direct and indirect 
ways. The indirect links are hard to isolate macro-economically, complex to describe, and empirically 
                                                      
3 Document WT/WGTDF/M/22. 
4 The choice of exchange rate regimes and their m acroeconomic implications have been well debated 
subjects since the collapse of the Bretto n-Woods system. A pre-requisite for an examination of this subject is a 
review of an equally rich literature on the classificati on of exchange rates regimes - both de facto and de jure. 
For a review of this branch of the literature (exchange rate regimes and implications), we recommend Qureshi, 
Mahavash and Charalambos Tsangarides (2010), The Empirics of Exchange Rate Regimes and Trade: Words 
vs. Deeds, IMF Working Paper WP/10/48.  
5 The terms "depreciation" and "devaluation" are used here interchangeably as the fall of the value of a 
country's currency relative to another cu rrency or to a basket of currencies. The latter term generally refers to 
the specific case where the currency was previously pegged to a metallic anchor such as gold or to another 
currency.  WT/WGTDF/W/57 
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hard to test, as they have second, third or fourth r ound effects. This is why exchange rates are often 
treated in models as external (exogenous) variables.  
2. The uncertainty generated by exchange rate risks 
8. As explained in the first IMF study on the matter (1984), exchange rates can in principle 
influence trade in many ways. Real exchange rate s, which are the relative prices of tradable to non-
tradable products, have a potentially strong impact on the incentive to allocate resources (capital and 
labour for example) between the sectors producing tradable and non-tradable goods. Real exchange 
rates are also a measure of real competitiveness, as they capture the relative prices, costs, and 
productivity of one particular country vis-à-vis the rest of the world.  
9. After a period of thirty years of relative st ability of both nominal and real exchange rates 
under the Bretton-Woods system, increased volatility of exchange rates from the early 1970's 
triggered a rich and lively debate on the channels  through which such increased volatility could affect 
the real economy. The concerns of the tradin g community, which had negotiated substantial 
reductions in border protection when the Gold Excha nge Standard determined exchange rates, were 
particularly strong. At the request of the then Dir ector-General of the GATT (on behalf of the General 
Council), the IMF examined the effects of greater exchange rate volatility on global trade. While 
concluding that the evidence concerning a negative e ffect of the increased volatility of exchange rates 
on global trade were slim, the 1984 IMF study clearly laid down the channels by which such increased volatility could affect trade. It describ ed, for example, how sustained misalignment of 
exchange rates away from levels that reflected in flation or cost differentials sent incorrect price 
signals which could destabilize international trade flows; how misalignment could inflict adjustment 
and resource misallocation costs on an economy if it changed investment decisions and resulted in 
shifts in resources between the sectors of an econom y that were not justified by relative cost and 
productivity differentials; and how misalignment might destabilize levels of protection against foreign 
competition provided by price-based trade restrict ions, generating pressure for compensating trade 
restrictions to protect current patterns of supply.
6  
10. Among all these transmission channels, the early (1970s and 1980s) theoretical analyses and 
models of the relationship between  exchange rates and international trade focused primarily on the 
commercial risk involved in conducting internationa l transactions and the uncertainty generated by 
short-term or longer-term volatility. How this uncertain ty affected the decision to trade, its expected 
profitability, and eventually the allocation of r esources between tradable and non-tradable goods and 
services was, then, the main target of attention.  
11. One simple but relatively well known example of how exchange rates affect trading firms is 
provided in a seminal paper by Clark (1973), who describes the hypothetical case of a firm, producing 
under perfectly competitive conditions a single pr oduct containing no imported input, entirely for 
export markets. The firm is paid only in foreig n currency, hence the proceeds of its exports in 
domestic currency depend on the (unpred ictable) level of the exchange rate. In the model, the firm is 
assumed to be small and to have limited access to currency hedging. In addition, because of the high 
cost of adjusting its levels of production to other factors than demand, it is also assumed that its output 
will not change in reaction to fa vourable or unfavourable changes in  the profitability of its exports 
deriving from exchange rate shifts . Uncertainty about future exchange  rates directly translates into 
uncertainty about future receipts in domestic currency. Thus the firm in question must determine a level of export that incorporates this uncertainty. If one considers that the firm maximizes its profit 
and has a risk aversion higher than zero, a prime cond ition for this firm to produce is that its marginal 
revenue exceeds its marginal cost to compensate fo r the exchange risk it bears. Hence, in this 
situation, in which the firm's variability of profits  depends only on the excha nge rate, greater volatility 
of that exchange rate - with no change necessarily in its average level - results in a reduction of output 
                                                      
6 Document WT/GC/444. WT/WGTDF/W/57 
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and exports, reflecting reduced exposur e to exchange rate risk. In other words, this basic model, later 
refined by Hooper and Kohlhagen (1978), establishes a rather negative relationship between exchange 
rate volatility and international trade.   
12. The view that an increase in exchange rate volatility will have adverse effects on the volume 
of international trade is relatively widespread in studies conducted throughout the 1970s and 1980s (in 
addition to Clark, Hooper and Kohlagen, see also, inter alia, Baron (1976) , Cushman (1983), Gros 
(1987), De Grauwe and Verfaille (1988), Giovannini  (1988), Bini-Smaghi (1991) and others, at a 
period of increased volatility (IMF, 1984). However,  these conclusions rest on relatively stringent 
assumptions, which have been scrutinized and relaxed by other authors - notably the assumption of perfect competition, the large role of the invoicing currency, the absence of imported inputs, the high 
aversion to risk, and the absence of exchange rate he dging financial instruments. This led the way to 
more sophisticated multi-country models with dive rsified firms, in which the relationship between 
exchange rates, the supply of goods and th e decision to trade became more ambiguous.  
13. For example, in the presence of imported inputs, the contraction in the supply of exports is 
smaller, as acknowledged by Clark himself, because  when an exporter imports inputs from a country 
whose currency depreciates, there is some offsetting effect on declining export revenues in the form 
of lower input costs. One may also take into account the possibility of firms hedging effectively 
against short-term fluctuations, and the likelihood of larger fi rms evolving in a multi-currency 
environment, in which the effect of fluctuations in one or the other direction on total profitability 
cancel out. The extent to which firms can allocate their output between the domestic and international 
market (and among international markets) also matte rs, as well as the risk aversion of firms towards 
price uncertainty. These factors led suggested that the link between greater exchange rate volatility 
and reduced trade flows was less robust than had initi ally appeared. On the other hand, the notion that 
exchange rate volatility affected could not be entirel y dismissed and may be relevant in some cases.  
For example, while many exporters can diversify their currency risk by mixing local and foreign 
currency invoicing (depending on their market powe r), exporters still faces a risk: when a firm 
invoices in foreign currency, it faces a price risk.  When it invoices in the domestic currency, it faces a 
quantity risk (the quantity dema nded is uncertain because the price facing the buyer is itself 
uncertain). Therefore, not only revenues become uncertain, but production costs as well (Baron,1976). 
14. In several models, the effect of increased vola tility of exchange rates on trade depends heavily 
on the level of risk aversion of traders (De Grau we,,1988); Dellas and Zilberfarb, 1993). Risk-neutral 
traders are unlikely to be affected by exchange ra te uncertainty but risk adverse ones will, albeit in 
different degrees. Paradoxically, for very risk-adver se traders, exporting more could be a response to 
increased volatility, in order to compensate for the expected fall in revenue per exported unit. As 
indicated by De Grauwe (1988), while "exporters are universally made unhappy by the volatility of 
exchange rates, some may decide that they will be better off exporting more". In this particular case, 
he stresses that the dominance of income eff ects over substitution effects results in a positive 
relationship between exchange rate fl uctuations and the volume of trade.
7  The existence of a positive 
relationship between exchange rate volatility and ex ports was later confirmed theoretically by Broll 
and Eckwert (1999), but only for firms that are able to  react flexibly to chang es in exchange rates and 
re-allocate their products among markets accordingly.   Such action is likely to optimize the gains 
from trade in an environment of increased volatility bu t would only work if the firms in question have 
large domestic markets at their disposal, allowing th em to rely on the domestic market in any case. As 
indicated by the authors, "the export strategy is like an option because the domestic market is certain 
whatever the realized exchange rate turns out to be. The domestic price is the "strike" price of the real 
                                                      
7 In De Grauwe's model, exchange rate variability has two effects on risk-adverse firms: an income 
effect, whereby the expected reduced utility derived from higher uncertainty of profits leads the firms to increase its sales abroad, and a substitution effect, whereby higher uncertainty deriving from volatile exchange 
rate would lead the firm to reduce trade. At the highest  level of risk aversion, th e income effect exceeds the 
substitution effect.  WT/WGTDF/W/57 
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export option." However, a more volatile exchange rate also implies a higher risk of exposure for 
international firms - with this effect working in the opposite direction. The authors conclude that the 
net effect of exchange rate uncertainty on produc tion and exports in their model would depend on the 
degree of relative risk aversion of the firm.  
15. The availability of financial hedging through forward exchange markets helps reduce the 
uncertainty generated by fluctuations of nominal exchange rates, although firms have unequal access 
to hedging facilities and may display different be haviour according to which side of the hedging 
position they stand. While Baron (1976) suggests that, in a world in which the only source of 
uncertainty is linked to exchange rates fluctuations , perfect forward markets neutralize the effects of 
exchange rate volatility on the volume of trade; Viaene and de Vries (1992) nuanced this conclusion 
by suggesting that forward markets create "loser s" and "winners" among e xporters and importers 
which are on the opposite sides of the forward tr ansactions. Besides, as noted by the IMF (1984), 
foreign exchange hedging contracts are not necessaril y available in all countries and to all categories 
of firms. Contracts are typically relatively large, ma turities short, and fees high. Besides, they only 
cover a limited share of possible fluctuations durin g the proposed maturities - as by definition it is 
hard to anticipate the magnitude of such fluctua tions. Hence, it is generally accepted that larger 
exporting firms are in a better position than smalle r firms to benefit from exchange rate hedging. 
Caporale and Doroodian (1994) confirm that hedging is available but generates costs and difficulties 
related to the firms' lack of foresight as to th e timing and volume of foreign exchange transactions. 
Obstfeld and Rogoff (1998) study the hedging "behaviour" of firms in relation to their risk aversion. They find that risk-adverse firms will hedge agains t exchange rate movements, but hedging costs and 
exchange rate uncertainty will tran slate into higher export prices, which will adversely affect (world) 
output and consumption.  
16. The assumption that exchange rates affect tr ade because firms cannot adjust production and 
factor inputs according to exchange rate fluctuations  has also been relaxed by several authors Gros, 
(1987) and De Grauwe, (1992) have worked with a wider spectrum of cases than those described by 
Clark.  If firms can adjust factors of production upwards and downwards acco rding to world prices, 
they are indeed likely to sell more when internati onal prices in foreign currency are high (with a limit 
set by the production capacity of the "flexible" fact or) and less when such prices are low. However, 
this will depend on risk aversion towards profit uncer tainty, with risk adverse firms less likely to 
export more as exchange rate volatility creates a highe r profit variance, with less risk adverse firms 
ready to sell more even in a context of profit uncer tainty (the opportunities created by price variability 
would offset the uncertainty about profit-making). 
17.  Somewhat more recent theoretical models of hysteresis in global trade show that the high 
variability of exchange rates and associated uncerta inty can influence the decision to enter or exit 
foreign trade markets, in the presence of "sunk" co sts (in particular, Dixit, 1989; Krugman,,1986; 
Franke,1991). The concept of "sunk" costs is lin ked to the fixed costs involved in setting up 
production networks for export-orie nted products, marketing tools and distribution infrastructures, 
and it fits well with the newer realities of modern tr ade patterns. In the presence of such costs, firms 
would tend to be less reactive to short-term fluctuati ons in exchange rates, in a sort of "wait-and-see" 
attitude. However, the deeper and longer these fluctu ations, the greater the incentive to stay out of 
international markets for firms that have not come in yet, and of staying in for firms having already 
invested entered the market. In other words, exchange rates encourage firms towards inertia. 
18. Some models emphasize the effects of exchange  rate variability more on the composition than 
on the gross volume of trade. Kumar (1992) indicat es that while the relationship between exchange 
rate fluctuations and gross levels of trade is am biguous, fluctuations have a positive impact on intra-
industry trade. The logic of the argument is that the exchange rate risk acts as a "tax" on the 
comparative advantage of the exporting sector re lative to the domestic sector. If comparative 
advantage is reduced, economies of trading countrie s will become less specialized and intra-industry WT/WGTDF/W/57 
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trade will increase at the expense of inter-industry trade.  In this model, exchan ge rate risk reduces net 
trade, which is the difference between gross trade and intra-industry trade. 
19. While the literature has focused mainly on the impact of exchange rate uncertainty on the 
incentive effects on trade, a few authors have exam ined the "reverse" correlation on the effects of 
international trade on exchange rates. Mundell' s (1961) optimal currency hypothesis suggests a 
reverse causality, whereby trade flows stabilize real exchange rate fluctuati ons, thus reducing real 
exchange rate volatility. Broda a nd Romalis (2003) add in the introduc tion of their paper that such 
causality ought to be addressed, as "most of the existing studies have focused on the effects of 
exchange rate regimes or volatility on trade by assu ming that the exchange rate process is driven by 
exogenous shocks and is unaffected by  other variables. By definition, this implies that the effect of 
trade on volatility is inexistent rather than jointly estimated with the effect of volatility on trade. 
(This) is not a benign assumption. (Our) figures show a strong positive relationship between real exchange rate volatility and distance between tradin g partners. Since distance cannot be affected by 
volatility, this strong relationship suggests that greater distance between countries significantly 
increases bilateral exchange rate  volatility through the effect of  distance on the intensity of 
commercial relationships such as trade. Ignoring th e causal effect of trade on volatility results in 
overestimates of the true impact of exchange rate  volatility on trade." The paper finds that deeper 
bilateral trading relations dampen real exchange rate volatility and are more likely to lead to a 
currency union. Controlling for that reverse causal ity, they also find that currency unions enhance 
trade by 10 to 25 per cent.     
20. The question arose as to whether,  in the examination of the literature on the direct link 
between exchange rate and trade, using real or nominal exchange rate would make a difference from 
an analytical point of view. In fact, most author s deal primarily with real exchange rates. The 
probability that the variability of nominal exchange rates did not translate into that of the real 
exchange rate would be small, occurring only duri ng exceptionally high periods of domestic inflation. 
In empirical studies, both variables are generally tested (cf. next section). 
3. Lessons from the empirical work, until the early 2000's 
21. Reflecting the relatively inconclusive state of ear ly theoretical models regarding the effects of 
exchange rate variability on trade, the vast em pirical work conducted by academics and policy-
oriented economists in support of theoretical c onsiderations leaves no less ambiguous evidence. As 
indicated by Taglioni (2002), "it is customarily presumed that the adverse effect of exchange rate volatility (on trade flows), if it exists, is certainly not large".  
22. This conclusion is shared by and large by  Ozturk (2006), which contains a fairly 
comprehensive account of the empirical surveys dedicat ed to the impact of exchange rate variability, 
published between the 1970s and the early 2000s. Th e broad results of the 43 surveys examined by 
him are summarized in Table 1 (Annex I). The survey s show differences in specifications, estimation 
techniques, sampling, and data sets. It concludes on  a rather wide mix of evidences, some in favour 
and some against the hypothesis of a negative relati onship between exchange rate volatility and trade. 
23.  These mixed conclusions are perhaps best illu strated in the IMF's 2004 study on exchange 
rate volatility and trade flows, see IMF (2004). The su rvey updated the earlier one completed in 1984, 
and hence incorporated the outcome of two decades of improvements in estimation techniques, data and theory. It allowed for an exploration of the effects of exchange rate volatility on trade along 
several new dimensions, for example by type of vol atility (short- and long-run, real and nominal, and 
other characteristics), by country group (with useful distinction by regions and income levels), and by 
type of trade (using disaggregated data  across different types of goods).  
24. 
The IMF's conclusion that there was no "obvi ous negative relationship between aggregate 
exchange rate volatility and aggregate trade" do es not differ fundamentally from that of the 1984  WT/WGTDF/W/57 
 Page 7 
 
 
study, but it is enriched by considerations regard ing bilateral trade. As indicated on page 41, "when 
we turn to bilateral trade, we do find evidence th at exchange rate volatility tends to reduce trade, 
(although) this negative effect is not robust to alte rnative ways of controlling for factors that could 
affect trade." 
25. This conclusion needs to be elaborated. In its examination of the relationship between 
exchange rate volatility and trade, the IMF looked at  the time paths of the two variables and found no 
obvious (negative) association. World trade increa sed steadily between 1970 and 2000, while the path 
of exchange rate volatility was less smooth. Exchan ge rate volatility showed an upward trend from the 
early 1970's through the end of the 1980s, before m oderating, with strong regional bulges such as in 
the case of transition economies from Eastern Europe (1990-94) and of the Asian crisis in 1997-98. 
As indicated in the study (page 44), negative asso ciations in such cases "may not reflect a causal 
relationship, but rather are the manifestation of th e effects of a common set of factors that both raise 
currency volatility and reduce trade. For example, the As ian crisis led to a large decline in the imports 
of the affected countries and major movements in their exchange rates, but the fall in domestic 
demand was the most important factor reducing im port volumes, not currency volatility. Similarly, the 
breakup of the Soviet Union caused widespread cu rrency dislocations in many transition economies, 
resulting in substantial falls in output and trade, a nd huge changes in many exchange rates that were 
part and parcel of the transition process. In orde r to estimate the specific impact of exchange rates 
(…) on trade flows, it is necessary to take account of the separate effects of the myriad of factors that 
determine the level of exports and imports". The IMF does this using a gravity model which tests 
other determinants besides exchange rates of tr ade patterns such as distance/geographical positions, 
GDP (or demand), and many other factors that may affect  transaction costs relevant to bilateral trade.8  
26. The detailed results indicate that long-term r eal exchange rate volatility "has a significant 
negative effect on trade - if exchange rates were to rise by one standard deviation in our sample, trade 
would fall by 7 per cent, (…) an effect that is co mparable to the estimates found by previous studies 
(page 48). However, the authors do not find the re lationship to be "robust to certain reasonable 
perturbation of the specification".9 When testing whether exchange rate variability had a different 
effect in differentiated or hom ogeneous products, the IMF wrote that "recent developments in the 
economics of trade suggest that a given increase in transaction costs (of which exchange rate volatility 
is a component) could have a larger, negative effect  on trade in differentiated products than on trade 
in homogeneous products (…), but, as with aggreg ate trade, estimation results show that this 
theoretical prior is not robust" (page 52). The IMF remains equally cautious on whether the effects of 
exchange rate variability differ across country gr oups, by acknowledging he dging opportunities were 
less developed in developing c ountries and hence could be associated with less trade in these 
countries.  This proposition proved, once again, no t to be so robust when subjected to quantitative 
tests. What comes across relatively strongly from th e study, though, is that members of a currency 
union tend to trade more - the IMF's core results confirming those of Rose (1999). As indicated in 
page 53, "the trade-enhancing benefits of cu rrency unions apparently far exceed gains from a 
reduction in exchange rate volatility and are preserve d over time". On balance, the IMF concludes that 
"for both aggregate and disaggregated trade, there is empirical evidence pointing to a generally small 
negative effect of exchange rate volatility on trad e, but this evidence is not overwhelming and not 
robust across different empirical specifications."   
                                                      
8 The gravity model used by the IMF performs re latively well empirically, yi elding coefficients and 
estimates in line with expectations deriving from other empirical work, and from economic theory. The 
coefficient for distance is statistical ly significant and negative, and the coefficient for GDP and other economic 
masses is equally statistically significant and positive. Other control variables yield the expected signs and 
significance. 
9 Specifically, when time varying country fixed effect s are allowed, which are suggested by theoretical 
work on the gravity model specification, "the analysis does not reveal a negative association between volatility 
and trade" (page 55). However, on page 49, it is stated that "a negative effect is still observed when we control 
for unobservable cultural, economic, historical, geographical and other factors specific to a given pair of 
countries rather than individual countries. WT/WGTDF/W/57 
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27. An interesting policy conclusion in the very last  paragraph of the study indicates that "prior 
consideration suggest that there do not appear to be strong grounds to take measures to reduce 
exchange rate movements from the perspective of pr omoting trade flows. Note that this does not rule 
out the possibility that exchange rate fluctuations  can affect the economy through other channels. For 
example, currency crises - special cases of exchange  rate volatility - have required painful adjustment 
in output and consumption. However, in this case, a ppropriate policies are those that help to avoid the 
underlying causes of large and unpredictable movement in exchange rates, rather than measures to 
moderate currency fluctuations direct ly for the purpose of enhancing trade." 
28.    Results of other leading authors confirm on aggregate those of the IMF: volatility decreases 
trade, although the effect is small and the results are not entirely robust to changes in specifications. 
Bilateral trade seems to be more affected than a ggregate trade.10 Trade in differentiated products is 
more affected than trade in commodities; and pa rticipation in a currency union had rather strong 
positive effects on trade flows. Of particular interest is the work of Dell'Ariccia (1998), which looks at 
the impact of exchange rate volatility on the b ilateral trade of EU 15 Me mbers and Switzerland over 
twenty years, from the mid-1970s to the mid-1990s . Depending on the measures of variability, he 
found a negative association between exchange rates and trade, and that trade would increase by 3 per 
cent to 13 per cent if this variability were brought down to zero. Rose (1999) found relatively similar 
results (small but significant negative effects) with  a wider data set - with trade also increasing by 
comparable levels should the variability disappear  between highly economically integrated trading 
partners.11 In addition, both Dell 'Ariccia and Rose found a fairly strong impact of a currency union 
on trade, as they tested the so-called "third country " effects of the volatility on trade, which tend to 
increase the impact of exchange rate variability ove r regional trade. Wei (1998) tested empirically - 
using data on 1,000 country pairs - the hypothesis according to which the difficulty in finding large and negative effects of exchange rate volatility on trade was due to the availability of hedging 
instruments. He found that there was no evidence in  the data to support the validity of the hedging 
hypothesis, and that for country pairs with larg e trade potential, exchange rate volatility deterred 
goods trade to an extent larger than typically docum ented in the literature (generally between 5 and 10 
per cent in the volume of bilateral trade). 
29. No method of estimation and underlying theore tical model was found to be "superior" to 
others in describing and computing the impact of exch ange rate variability on tr ade flows. In a general 
equilibrium framework, the complex interactions of all the major macroeconomic variables were 
taken into account in a multiple country environm ent. In such models, all the implications of 
exchange rate changes were tested , even if offsetting one another. In partial equilibrium models, the 
direct effect of exchange rate changes can only be tested on another vari able (level of trade) 
regardless of whether volatility affects the other va riables that influence trade. Bacchetta and Van 
Wincoop (2000) used a general equilibrium model,  in which uncertainty arises from monetary and 
fiscal policy, to examine the impact of volatility on th e levels of trade and welfare in a context of both 
fixed and flexible arrangements. One interesting out come illustrating the complexity of the exchange 
rate-trade relationship is that m onetary stimulus in a country, that leads to the depreciation of its 
exchange rate may not have much effect on trade, as the depreciation of the exchange rate on the one 
hand reduces imports, but on the other hand, the incr ease in domestic demand linked to the monetary 
stimulus may boost imports in an offsetting moveme nt. Of course, the net effect will depend on a 
whole set of variables, from demand elasticities for im ports to supply-side factors, such as the desire 
or ability of domestic producers to adjust prices to the depreciation of the currency. Similarly, 
standard macroeconomic theory describes the J-curv e effects of exchange rate depreciations (see 
                                                      
10 Several papers submitted by WTO members point to the impact of exchange rate shifts on bilateral 
trade or on the aggregate the trade balance. For example, Rincon (1999) finds that, over the period 1979 to 1995, 
exchange rate depreciation of the Colombian currency had an important role in the short- and long-term 
improvement of the Colombian trade balance.     
11 In earlier work, though, Rose (1991) had found no evidence of a negative relationship between 
exchange rates and trade on a set of G-7 countries in the 1980s.  WT/WGTDF/W/57 
 Page 9 
 
 
section (d) of part B.), generally with a sufficient degree of detail to establish that real effects of nominal exchange rate changes will depend on a comp lex set of variables that will or will not induce 
domestic firms to increase exports or domestic consumers to increase imports.  Such variables include 
the extent of imported inflation, whether exporting firms are price-takers or price-makers, the price-
setting mechanisms of firms, and so on).  
B. T
HE LATER LITERATURE (FOLLOWING THE 2004  IMF STUDY ): TESTING THE EFFECT OF 
EXCHANGE RATE MISALIGNMENT  
30. As indicated by the OECD (2011a), the economic  crisis has had a "di fferentiated impact on 
the world economies and on their trade, thereby ch anging trade patterns in some cases". The on-going 
debate about exchange rate movements and their impact on trade balances rebounded in the aftermath 
of the crisis, with concerns about unemployment and slow recovery strengthening the sensitivity and 
vigilance towards those countries susp ected of "exporting" their way out of the crisis at the expense of 
their trading partners. Such concerns already exis ted in the 2000s, in an international environment 
characterized, inter alia, by the devel opment of global external imbalances. 
31. The policy and academic debate shifted somewhat at this time, away from the effects on trade 
of exchange volatility towards the effects of sust ained exchange rate depreciation or perceived 
exchange rate misalignments.  This  meant emphasis fell less on the e ffects of variability and more on 
the real level of the exchange rate12  While this sh ift in focus reflects the policy concerns regarding 
the potential impact of sustained currency misalig nment, economic research shows that new global 
patterns of trade have rendered the effects of excha nge rates on trade even more complex. In this area 
research is still it its infancy. 
1. Exchange rate levels and trade 
(a) Theoretical work: Transitory or permanent effects? 
32. Exchange rates can depart from their equilibrium  level for two reasons.  First, as a result of 
government intervention directly aimed at altering the real exchange rate (currency manipulation).  In 
this respect, governments and/or central banks possess a number of policy instruments that can affect 
the real value of the exchange rate, including the introduction of capital controls or targeted 
intervention in foreign exchange markets.  Second, misalignments can be the uni ntended side effect of 
macroeconomic policies aimed at achieving domestic objectives, or the result of distortions in the 
international financial architecture or in domestic st ructural conditions.  There is an academic debate 
on the extent to which the real exchange rate is a variable that policy makers can influence, see for 
instance, Eichengreen (2007) and Rodrik (2008).  In  addition, to ascertain the root cause of a currency 
misalignment is often a difficult matter in practi ce.  The ensuing discussion will abstract from the 
cause of the misalignment and will, instead, focus on its tr ade effects in the long- versus the short-run.   
33. Standard economic theory defines the long-run as the period in which all prices are fully 
flexible.  Put differently, in the long-run prices have  the time to adjust to any policy change (or other 
shock).  In this context, money is like a veil to the real economy, an intuition that dates back at least to 
David Hume's essays on money and the balance of tr ade.  In particular, when markets have no 
distortions, an exchange rate misalignment - such as a devaluation of the currency - has no long-run 
effect on trade flows or on real economic activity, as it does not change relative prices.  The short-run, on the other hand, can be different.  The reason is that, if some prices in the economy take time to 
adjust (i.e. are "sticky"), movements in nominal ex change rates can alter relative prices and affect 
both the allocation of resources between non-tradable  and tradable sectors and international trade 
flows.   
                                                      
12 As noted in the last sub-section of part B, research  on the impact of exchange rate volatility and trade 
has nevertheless continued and deepened. WT/WGTDF/W/57 
Page 10  
 
34. The short-run trade effects of exchange rate misalignments, however, are not straightforward, 
see Staiger and Sykes (2010).  Recent macroeconom ic literature shows that these effects depend, 
among other things, on the currency in which domestic producers invoice their products.  For 
instance, if producers set their price in the home currency (or if domestic wages are sticky), an 
unanticipated devaluation lowers the price of dome stic goods relative to foreign goods.  This case, 
which has been much debated in policy circles in  recent times, has similarities (even if it is not 
perfectly equivalent) to the imposition of a combin ation of export subsidy and import tariff on all 
goods –an argument first made by Keynes in 1931.13  However, the trade effect of a devaluation 
would be different if domestic producers were to set their price in the buyers' currency or in a vehicle 
currency, such as the US Dollar or the Euro.  In the latter cases, the theory suggests that a devaluation 
would still have real effects, but such consequences would not be equivalent to export promotion, but 
rather to import restrictions, see Staiger and Syk es (2010).  These authors conclude that understanding 
the short-run impact of an exchange rate devaluat ion on trade flows is conceptually more difficult 
than it may appear at first sight. 
35. The above argument abstracts from the possibility of market failures.  For instance, in the 
presence of information problems (e.g. the quality of  export goods is unknown to foreign consumers), 
it has been argued that the level of exports may be inefficiently low (Bagwell and Staiger, 1988; 
Bagwell, 1991). A high-quality exporter may need to signal quality, which is costly.  Firms may also 
have common uncertainty about the profitability of  exporting, and such common uncertainty suggests 
the existence of a coordination problem -- see, in particular, the study by Freund and Pierola (2010) on exports from Peru.  In this context, the unde rvaluation of the exchange rate may have long-run 
effects if it allows exporters to enter foreign ma rkets, thus overcoming the initial inefficiency.  
Specifically, if this logic is correct, one would e xpect that currency depreciation is associated with 
entry into new markets and new product lines (i.e. the ex tensive margin of trade), and that it is not (or 
not completely) undone in the long-run when prices adjust.  Moreover, as market failures are considered to play a more prominent role in developing as opposed to developed economies, one 
should expect that these long-run effects ar e weaker for the latter group of countries. 
36. A related literature analyses the relationship betw een the exchange rate and income growth.  
Economists have long known that avoiding overvaluati on of the currency is an important factor for a 
country's economic performance (Rodrik, 2008).  While  economic models have rarely formalized the 
association between overvaluation and slow grow th, most accounts link it to macroeconomic 
instability (Fischer, 1993; Easterly, 2005).  A rela ted question is whether the undervaluation of the 
currency can have benign effects on a country's perfor mance.  A series of recent papers by Hausman 
et al. (2005); Eichengreen (2007); Rodrik (1986 an d 2008); Korinek and Serven (2010) show that a 
devaluation can play an important part in the growth process of developing countries.  The logic is still related to the possibility of market failures.   Specifically, these models assume that market 
imperfections (e.g. learning externalities, product ma rket failures) are more prominent in the tradable 
sector relative to the non-tradable.  As a result,  undervaluation has a positive impact on growth as it 
alleviates the economic costs of market distortions  by promoting the expansion of the tradable 
activities.  However, an economic argument can also  be made that an exchange rate undervaluation 
can hamper growth by providing a wrong signal to  economic agents, which may lead to factor 
misallocation (Haddad and Pancaro, 2010).  
37. The literature on exchange rates and growth does not directly address the question of the trade 
effects of a currency undervaluation or overvaluation.   Economic logic suggests that there are at least 
two opposite effects at work.  An undervaluation of  the currency has a direct negative effect on the 
exports of other economies that specialize in th e production of goods that are relatively close 
substitutes and compete for market share in simila r export markets.  On the other hand, income 
growth of trading partners has an indi rect positive effect on export performance. 
                                                      
13 Several authors made this point, including among others Bergsten (2007) and Mattoo and 
Subramanian (2009).  WT/WGTDF/W/57 
 Page 11 
 
 
38. Ultimately, whether exchange rates undervaluation can have an effect on trade in the short- 
and or the long-run is an empirical question (see the discussion below).  And specifically, one would 
argue that whether the long-run effects materiali ze depends on whether the market failures discussed 
above are empirically important.  Whatever the an swer to these questions, economic theory suggests 
two important caveats.  First, according to the so called "targeting principle" in economics, policies 
that target directly market failures are efficient (i.e. first-best).  Therefore, changes in the level of the 
exchange rate that address distortions only indi rectly can at most be second-best (among others, 
Rodrik, 2008).  Specifically, a real undervaluation creates unnecessary distortions by imposing a consumption tax on tradable goods.  The second cav eat is that the extent to which currency 
undervaluation is expected to have trade (or growth ) effects depends on what other countries will do.  
Even if one takes the view that an exchange rate undervaluation has a pos itive long-run effect on 
exports and growth, this would not hold if a ll countries undervalue at once (among others, Blair 
Henry, 2008).  
(b) Empirical work: devaluations, growth and export surges 
39. The issue of exchange rate levels and their relationship with other major economic variables 
such as growth, income, current account balances, co nsumption and trade have led to a great deal of 
discussion since the beginning of the mid-2000s, in particular when global imbalances started to 
widen.  
40. Even if the literature has not yet achieved a de finitive consensus regarding the best definition 
of the long-term equilibrium real exchange rate, Nassif et al. (2011) recall that various empirical papers have studied the impact that exchange rate overvaluations or unde rvaluations can have on 
growth. In particular, some studies have found that overvaluation hinders economic growth (Razin 
and Collins, 1999; Johnson et al., 2007; Rajan and Subramanian, 2009; Gala , 2008).  Others have 
found that undervaluation boosts gr owth (Rodrik, 2008 and Berg and Miao, 2010). Furthermore, other 
studies suggest that the relation between exchange  rates and growth is non-linear. For example, 
Williamson (2008) argues that a small undervaluation can  benefit growth. In the particular case of 
Brazil, for the period 1996-2009, Barbosa et al. (2010) found that both r eal appreciations and 
depreciations can have negative e ffects on growth. Similarly, Hadda d and Pancaro (2010) in a panel 
of 187 countries for the period 1950-2004 found that  a real undervaluation has a positive effect on the 
economic growth of low income countries in the short-run, but a negative effect in the long-run.  
41. A number of papers have looked at the empi rical relationship between exchange rate 
devaluation and export surges.  A series of studies have focused on the specific experience of certain 
countries and/or regions.  For instance, Fang et al.  (2006) analyse the effect of exchange rate 
depreciation on exports for eight Asian economi es (Malaysia, Philippines, Indonesia, Japan, 
Singapore, Chinese Taipei, Republic of Korea a nd Thailand). They find that a depreciation 
encourages exports for most countries, but its contri bution to export growth is weak and varies across 
countries.  They argue that the reason for this fi nding is that a depreciation raises exports, but the 
associated exchange rate risk (var iability) has an offsetting effect.  Bernard and Jensen (2004) focus 
on the US between 1987 and 1992.  In analysing the sources of manufacturing export booms, they 
find that changes in exchange rates were an importa nt determinant of export increases.  Most of the 
increase in exports was on the intensive rather than the extensive margin (i.e. increasing export 
intensity among existing exporters rather than from new entry into exporting).  Finally, Arslan and 
van Wijnbergen (1993) study the export boom  of Turkey in the 1980s and assess the relative 
contribution of different factors, such as export subsidies, import growth in the Middle East and 
exchange rate depreciation.  They find that the stea dy real depreciation of the Turkish Lira played an 
important role in the surge in exports.  
42. Two recent studies focus on a cross-country analysis.  Freund and Pierola (2008) examined 
the determinants of 92 episodes of export surges, which they defined as increases in manufacturing 
exports of at least 6 per cent that lasted for a period of seven years or longer.  They found that large WT/WGTDF/W/57 
Page 12  
 
depreciations of the real exchange rate were an important determinant of export surges for developing 
countries. Specifically, an undervalued exchange rate  had a positive effect by facilitating entry in new 
export products and new markets. These new pr oducts and markets accounted for 25 per cent of 
export growth on average during the surge in deve loping countries.   Haddad and Pancaro (2010) 
provide further evidence of the links between the r eal exchange rate and export expansion.  They 
found a positive association between the two variabl es, but only for low per capita income countries.  
Specifically, in developing economies with per capita  income below 2,500 USD, an increase in 50 per 
cent in real undervaluation is asso ciated with an annual 1.8 per cen t increase in export over gross 
domestic product (GDP) in the corresponding five year period.  However, they find that in the long-run the effect of a real exchange rate undervalua tion on exports becomes statistically insignificant for 
all income levels. 
(c) The trade balance and the J-curve debate 
43. Under the J-curve effect, often explained in international economics textbooks (e.g. Krugman 
and Obstfeld, 2003), the depreciation of the real  exchange rate is often synonymous with a 
deterioration of the trade balance of a given count ry in the short-run, because most import and export 
orders are placed several months in advance. The va lue of the pre-contracted level of imports rises in 
terms of domestic products, which implies that there is an initial fall in the current account. Moreover, 
if there is a high import content of exports, firm s may need some time in order to adopt new 
production techniques.The increase in import prices may be partly or fully offset by the substitution, if 
available, of imported goods by local goods, but th is implies an adjustment in the capacity of 
domestic firms which requires time. Besides, in or der to increase their sales abroad exporters may 
need to adjust their capacity to reach foreign cons umers, which may also take time. In the long-run, 
when these adjustments have taken place, a real ex change rate depreciation may improve the current 
account. 
44. In this respect, the OECD has in particular st udied the trade impact of changes in exchange 
rates for the world's three largest economies, na mely the United States, the euro-zone and China 
(OECD, 2011a). They found that on aggregate, shor t-run exchange rate movements impact trade but 
that "their effect is difficult to interpret; in some cases, the impact is positive, in others the impact is 
negative. These patterns are in line with other studi es which conclude that short-run effects do not 
seem to follow a specific pattern". They also find a more pronounced impact of exchange rates on 
exports of agricultural goods than on manufactured  goods. According to the authors, one reason for 
this may be the relatively "greater ease to change  suppliers of agricultural goods than manufacturing, 
owing to the fact that the former are more ho mogeneous than the latter". Moreover, "the price 
transmission mechanisms may be different in agriculture as compared with manufacturing and mining products". 
45. Details of the study show that the value of trade between the United States and China would 
be more affected by currency changes than that of the US-euro area or the euro area-China. The 
model applies a hypothetical 10 per cent depreciation of the various currencies on bilateral trade, 
based on 2008 trade data. According to model results,  a hypothetical 10 per cent depreciation of the 
US dollar (or a 10 per cent appreciation of the Yu an) would have implied an increase in the US 
agricultural trade surplus of around US dollar 5 billion and a decrease of the manufacturing trade deficit of some $30 billion. The authors put these results in perspective by indicating that this 
hypothetical depreciation would have reduced the US bilateral trade deficit with China from an actual 
US dollar 270 billion in that year to US dollar 235 billion, a decrease in the deficit by some 13 per 
cent. The OECD considers that this outcome goes in the direction of some recent academic papers (Evenett, 2010) suggesting that th e trade imbalance between the United States and China is due to a 
number of factors, of which the exchange rate is (only) one.   
46. Model results show that Euro-area trade with China would be less affected by movements of 
the exchange rate.   According to OECD calculati ons, a 10 per cent depreciation of the euro (equal to  WT/WGTDF/W/57 
 Page 13 
 
 
a 10 per cent appreciation of the Yuan) would only reduce the euro-zone trade deficit towards China 
by 9 billion euros, to 109 billion euros. The compositi on of trade seems to partly explain this lesser 
effect of the exchange rate, as the demand of trad ed goods with China seems to be less elastic to 
prices. Besides, the OECD "indicates" that "inter national price movements in the agricultural sector 
are also somewhat mitigated by ta riff structures which include a large share of specific (as opposed to 
ad valorem) tariffs." In the case of euro area trade with the United States, a 10 per cent depreciation of 
the euro would have resulted in a 20 billion euros increase in the existing tr ade surplus of the euro-
zone of 50 billion euros vis-à-vis the United Stat es (3 billion in the farming sector, 17 billion in 
manufacturing).  
47. As in most other macroeconomic studies, the main driver of trade flows was found to be 
income/demand levels, i.e. domes tic income/demand for imports a nd foreign income/demand in the 
case of exports. This finding was generally robust both at  the bilateral and global trade levels, and also 
at the country and sector levels. The OECD, however , cautions in conclusion regarding some of the 
limitation of such studies. In some cases, the coe fficients of the estimates are not stastistically 
significant. In the cases where coeffici ents are significant, their impact can move in either direction -- 
positive or negative. As written by the OECD, "this an alysis confirms much of the existing literature 
in that short-run effects of the exchange rate on tr ade are limited. This analysis does not confirm the 
existence of the J-curve in the short-run although it may point to a longer-term interpretation of the J-
curve, (whereby) a short-term deterioration of the trade balance is followed by a long-run 
improvement.  
48. In a companion paper, the OECD (2011b) examin ed the impact of exchange rate shifts on 
trade in two small open economies - Chile and New Zealand - and found that small economies trade 
tends to be more impacted by exchange rate cha nges than larger economies su ch as the United States, 
the euro-zone and China.  This finding is consiste nt with earlier theoretical and empirical literature. 
The OECD simulated hypothetical depreciations or  appreciations of 10 per cent of these countries' 
exchange rates to see their impact on their bilate ral trade with the United States, the euro-zone and 
China. It found that smaller, open economies such as  New Zealand and Chile ha ve to bear the full 
adjustment of exchange rate changes, relative to  less trade-dependent, large economies. One reason is 
that smaller economies have less a diversified pr oduction and export base, and hence are less in a 
position to move into exports that have greater price elasticity, when exchange rate appreciation 
results in potentially more costly exports. The ar gument is symmetrical for depreciations, i.e. the 
number of domestic producers is smaller and hence in sufficient to substitute for imports when prices 
increase. In the long-run, though, the relationship seems to be less certain. For example, the impact of 
a 10 per cent depreciation of the Chilean Peso depends very much on the trading partner and the sector concerned. Imports from China and the euro-zone  are relatively less affected than imports from 
the United States (largely as a result of the latter's high agricultural content). A 10 per cent appreciation of the Peso has a relatively large (positiv e) impact on Chile's exports to China, a large 
importer of extractive products - a result not so surprising because of the relative inelasticity of 
China's imports of copper (Chile's main export) to  international prices. The simulations confirm the 
observation of the companion paper, that many  fundamentals affect the relationship between 
exchange rate and trade, namely, the price elasticity  of each traded product, the country's market share 
of the product concerned, the product composition of  exports and imports, th e pricing strategy of 
importers and exporters, etc. Many of these paramete rs work in opposite directions. Therefore, the 
study concludes that the level of the exchange rate  is only one factor that influences trade balances. 
(d) Heterogeneous firms and gl obal production chains 
49. Until the mid-2000s most of the literature looked at the impact of exchange rate changes on 
aggregate imports and exports. Since then, progress h as been made in gathering information on firm-
level exports and can be examined in the context of  "new-new" trade models, in which the differences 
in behaviour among firms (heterogeneity) drive macroeconomic variables. The concept of WT/WGTDF/W/57 
Page 14  
 
"heterogeneity" of firms has opened a new flow of literature describing the "optimal" behaviour of 
firms based on their specific cost structure, pricing strategy and performance.  
50. Adopting this approach, a particularly  interesting paper by Berman et al . (2009) examines 
both at the theoretical and empirical levels why hi gh- and low-performance firms react differently to 
exchange rate changes (performan ce being measured in this model by a mix of productivity and 
quality benchmarks). The authors assume that fixe d export costs generate a selection process by 
which only the best performing firms are likely to  engage into exports, although exchange rate 
depreciation will provide an incentive for new firms, albeit not necessarily the most efficient, to enter 
export markets. They find that, following a depreci ation of the exchange rate, the high-performing 
firms are more likely to (partially) "absorb" the ex change rate movement in their mark-ups, rather 
than increase their export volumes. Low performing firm s tend to adopt the inverse strategy, i.e. they 
do not change export prices according to exchange rat es shifts. One of their conclusions is that since 
the highest performing firms are the largest exporte rs, the prices of tradable goods are relatively 
insensitive to exchange rate movements.
14 It follows that exporting, because it requires a high level of 
performance, induces firms to absorb  exchange rate movements into prices - hence exchange rates 
have only a limited effect on import prices and trade volumes as a result of the "natural" selection 
process of exporting.  
51. The export sector is not the only one where analytical progress has been made. The 
improvement in input-output tables and data by sect or has also allowed a more thorough examination 
of the linkages between the external and domestic sectors of an economy following a shock - such as 
real exchange rate changes. In a recent paper by  Rusher and Wolff (2009), trade balance adjustments 
would only happen if the exchange rate affected th e competitiveness of both the (externally) tradable 
and non-tradable sectors. In other words, the rela tionship between trade balances and real exchange 
rates would not be statistically significant if only the tradable sector was taken into account. In a single market, despite the low level of substitu tion of goods between the two sectors, competitive 
effects of the exchange rate would have to pass-thr ough from the tradable to the non-tradable sector to 
have an impact eventually on the trade balance.  
52. Product-level analysis has been one feature of the work conducted by Bahmani-Oskoosee and 
Wang (2007), who examined the impact of exchange  rates on trade flows between the United States 
and its trading partners, notably with China, Japan, Korea (Rep. of), Thailand and others.  Trade flows 
were broken down to the individual commodity level.  In this work, the use of trade data at the 
commodity level (two or three-digit industry trade data) permits the identification of industries that 
have been sensitive to exchange rate changes. The paper studying US-China trade over the period 
1978-2002 finds that the evolution of the bilateral real  exchange rate had an impact on many of the 88 
industries tested, although wide differences exist amo ng products. It seems that the appreciation of the 
dollar against the Yuan decreased US export earni ngs in 18 industries, while it increased import 
values in 40 industries. The asymmetrical impact of  the exchange rate seems in this case to be 
attributable to a lower price elasticity of Chinese demand to US manufacturing products rather than of 
US demand to Chinese manufacturing exports. 
53. A final consideration is that the relationship between exchange rates and trade is not an 
immutable one.  As recently as 30 years ago, produc ts were assembled in one country, mostly using 
inputs from that same country.  The emergence of  global supply chains in  recent decades has been 
accompanied by a dramatic expansion of aggregate international trade flows, as intermediate goods 
increasingly cross national boundaries several times during production.  As a result of this 
                                                      
14 Simulations showed that above me dian-performance French firms in their panel react to a 10 per cent 
depreciation by increasing destination- specific export prices in euros by some 2 per cent.  Below median 
performance firms kept their prices unchanged. The inverse was true for export volumes. The high performance 
firms kept their export volumes unchanged while belo w median performance firm s increased their export 
volumes by 6 per cent in the face of a10 per cent depreciation.   WT/WGTDF/W/57 
 Page 15 
 
 
development in the world economy, most imports should be stamped "made in the world" rather than in any specific country.  In this environment, the relationship between excha nge rates and trade flows 
may be substantially different.   For example, when the competitiveness of national exports depends 
upon the availability of imported components, or when  the final goods imported have a large national 
content that is reimported after processing abroad, then an exchange rate devaluation may have a 
negative short-run impact on national export industries.  Similarly, the cost of exchange rate volatility 
may be more pronounced when intermediate goods ha ve to cross several borders because buyers and 
suppliers are located in different countries.  Thes e simple observations suggest that the relationship 
between exchange rates and trade varies over time, as changes in the world economy materialize.   
54. For instance, Zhao and Xing (2006) analyse the effect of exchange rates on the outsourcing 
decision of multinational enterprises (MNEs) and show  that in this context currency appreciation has 
unconventional effects.  The paper proposes a theo retical model with multiple destinations for 
outsourcing in countries with relatively low production costs.   MNEs can shift their production to the 
next lowest cost country as a result of the apprecia tion in one country in order to minimize costs.  
Specifically, there are two consequences of the appreci ation.  First, the appreciation may or may not 
narrow the wage gap enough to lead to a repatr iation of the MNE to the higher cost country 
(supposedly the country of origin of the MNE), de pending in which country the currency appreciation 
takes place.  Second, the overall production cost or cost structure of MNEs would increase.  Hence, 
currency appreciation in a developing (low cost) country may well have a negative impact on the 
advanced economy, depending on the structure of global supply chains.  
55. The effects of exchange rate appreciation on tr ade in the context of global supply chains are 
addressed in several recent country studies. For instance, the IMF Spillover Report on China (IMF, 
2011) analyses the main factors of concern for a larg e set of countries following a shock originating in 
China.  An issue taken up in the report is the impact that a potential RMB revaluation would have on the world economy.  The report finds that, in the ab sence of other structural reforms (such as financial 
sector reforms), an appreciation would lead to lower output in China and lower Chinese demand for 
intermediate goods from other Asian countries, implying a suboptimal equilibrium. As a consequence, 
a RMB appreciation would benefit final goods produ cers such as Japan and the Republic of Korea, 
but it may (initially) hurt intermediate  goods producers in emerging Asia. 
56. Arunachalaramanan and Golait (2011) examine th e effect of a revaluation of the Chinese 
RMB on India’s bilateral trade bala nce with China.  They find th at an appreciation of the RMB 
against the Rupee would not improve the bilateral trade balance from the Indian perspective.  The 
authors argue that there are two main reasons that  explain their result.  First, the long-run price-
elasticity of demand for Indian goods in China is lower than that for Chinese goods in India.  Should 
Indian exports to China be cheaper, Chinese c onsumers would not easily substitute domestic for 
foreign goods.  Second, Chinese electronics and mach inery goods, which represent up to 40 per cent 
of total imports from China, are very important for domestic production in India.  Therefore, an 
appreciation of the RMB would raise the cost of in termediate products that are not easily substitutable 
in the short-run. 
2. Exchange rate volatility and trade 
57. The stream of literature on exchange rate volatility and trade has continued to produce both 
theoretical and empirical papers, without cha nging the broad thrust of previous, relatively 
inconclusive analyses and evidence.
15 
58. From a theoretical point of view, one of the ma in recent contributions comes from Brollet et 
al. (2006), who studied optimum production decisions by  an international firm using portfolio theory.  
                                                      
15 The IMF has brought the attention of the Secret ariat to several of the studies and references 
contained in this section. WT/WGTDF/W/57 
Page 16  
 
It is shown that an increase in exchange rate ri sk (or expectation thereof) could have a negative, 
positive or neutral impact on trade. The impact depends upon the elasticity of risk aversion with 
respect to the standard deviation (or the mean) of the firm's random profit. These results tend to 
confirm those of Bacchetta and Van Wincoop (2000). Empirical papers continue to provide a wide 
range of evidences, in some cases finding a robust  negative relationship between exchange rate 
volatility and trade, in other cases not. Despite pr ogress in estimation techniques and data sets, the 
outcome of the empirical literature remains as in conclusive as it has been in the previous three 
decades. As well summarized by Coric and Pugh (2010), which looked in detail at all the recent empirical work: "on average, exchange rate variabilit y exerts a negative effect on international trade. 
Yet, […] this result is highly conditional. […] [A]v erage trade effects are not sufficiently robust to 
generalize across countries." All in all, they found 33 studies emphasizing a negative relationship 
between exchange rate variability and trade volume and 25 studies leading to the inverse conclusion. 
Most of these studies are mentioned, with greater detail, by Ozturk (2006), in Annex I. 
59. Among the recent empirical studies that find a positive correlation between exchange rate 
volatility and aggregate exports, one can mention Klein and Shambaugh (2006), which is also in 
agreement with the previously mentioned line of thou ght that defends the existence of a positive effect 
of currency unions on trade (a survey of empiri cal work on the positive trade effects of currency 
unions has just been completed by Eicher and He nn (2009)).16 Rahman and Serletis (2009) found that 
exchange rate uncertainty has had a generally nega tive and significant effect on recent US exports, but 
that exports responded asymmetrically to positive an d negative exchange rate shocks. In a gravity 
model using 25 years of quarterly data and co-integ ration techniques, Chitet et al. (2010) examined 
the real exports of five emerging East Asian economies among themselves, as well as to thirteen 
industrialised countries. The paper provides strong evidence that exchange rate volatility has had a 
statistically significant negative impact on the expor ts of those emerging East Asian economies. They 
also tested the impact of exchange rate volatilit y of third countries to establish whether a rise in 
exchange rate volatility between the importing c ountry and other exporting countries encouraged 
bilateral exports between two tradi ng partners. Their findings tend to  confirm that not only absolute 
volatility but also relative volatility is important fo r bilateral export flows of emerging East Asian 
economies. They conclude that exchange rate volatility in East Asian economies has a significant 
negative impact on export flows to the world mark et. Ozturk and Kalyoncu (2009) applied similar 
techniques to another six countries, and found th at, over the period 1980-2005, exchange rate 
uncertainty exerted a significant negative effect on tr ade for the Republic of  Korea, Pakistan, Poland 
and South Africa, but a positive effect for Turkey  and Hungary.  Arize et al. (2000) focused on the 
impact of exchange rate volatility on export demand to  least developed countries (thirteen), and found 
a negative relationship between vola tility and exports both in the short-  and long-run. Volatility seems 
to be felt by least-developed countries even more as forward markets are not accessible to many of 
them, limiting their ability to hedge against th e main currency's movements and increasing their 
traders' risk aversion.  
60. On the other hand, other authors have failed to  find any robust, negative relationship between 
exchange rates and aggregate trade. This is the case with Hondroyiannis et al. (2008). They use a 
sample of 12 industrialized countries, for which they  failed to find a significant effect over the period 
1977-2003. They conclude that “the finding of a significant and negative impact of volatility is 
attributable to specification biases.” Boug and Fa gereng (2010) found no "evidence suggesting that 
export performance (of Norwegian firms) has been  significantly affected by exchange rate 
uncertainty". Tenreyro (2007) used an estimati on approach to simultaneously address all biases 
identified in previous literature, in particular the reverse causality problem. She found no significant 
impact of nominal exchange rate volatility on trade flows. Some recent studies incorporating 
exchange rate volatility in a gravity equation settin g do not find a robust impact of exchange rate 
volatility (Eicher and Henn, 2009). Baum and Caglay an (2010) also conclude that exchange rate 
                                                      
16 However, for a more pessimistic view of this po sitive relationship, see Santos Silva and Tenreyro 
(2010).   WT/WGTDF/W/57 
 Page 17 
 
 
volatility does not have an impact on the level of trade, but they do find a robust positive link to the volatility of bilateral trade flows.  
61. The literature on the effects of exchange rate volatility is also taking into account the above-
mentioned progress on sectoral analysis, with a view  to eliminating the aggregation biases deriving 
from the use of total exports data . Wang and Barrett (2007) state in their study that "due to data 
limitation, most studies employ low frequency quarterl y or annual series to examine the trade and risk 
relationship". In one of their earlier papers Wa ng et al. (2002) demonstrated that "temporal 
aggregation necessarily dampens exchange rate va riability, which may make identifying any true 
trade-risk relationship more difficult. Furthermor e, since trade contracts in many sectors include 
agreement for delivery in less than  90 days, even quarterly frequency data may be aggregating trade 
flows excessively to identify short-term fluctuations in response to predicted changes in exchange rate 
levels or volatility". Correcting for these weakness es, Wang and Barrett (2007) looked at the effects 
of exchange rate volatility on trade in eight sector s between the United States and Chinese Taipei over 
the period 1989-1998, and found that volatility affected  agricultural flows, but not those in other 
sectors. The hypothesis under which agricultural trad e is more sensitive to (negatively affected by) 
long-run exchange rate uncertainty than other sectors is confirmed by Cho et al. (2002) using a panel 
of ten OECD countries over the period 1974-1995. 
62. Generally, studies using disaggregated data te nd to find a more robust negative relationship 
between exchange rate volatility and trade flows, al beit not systemically, neither for all sectors nor for 
all countries. This is in particular the case in Peri dy (2003), who showed that the impact of exchange 
rate volatility on exports of G-7 countries varies considerably depending on the industry covered and 
the destination market, partly as a result of bot h sectoral and geographical aggregation biases in the 
aggregate data. He found mostly negative effects for exchange rate volatility, but for several countries 
and sectors these are not statistically significant. Bryne et al. (2008) consider the impact of exchange 
rate volatility on the volume of bilateral US trade (both exports and imports) using sectoral data. They 
found that separating trade into differentiated goo ds and homogeneous goods results in the most 
appropriate sectoral division. Thus, exchange rate vo latility is found to have a robust and significantly 
negative effect across sectors, a lthough it is strongest for exports of differentiated goods. Bahmani-
Oskooee and Hegerty (2008) looked at the impact of increased exchange rate volatility since 1973 on 
US-Japan bilateral trade. They used disaggreg ated data for 117 Japanese industries from 1973 to 
2006. They found that in the short-run some industries are influenced by exchange rate volatility, although this effect is often ambiguous. In the long-r un, trade shares of most industries are relatively 
unaffected by exchange rate uncertainty, while so me industries experience a relative shift in their 
proportion of overall trade. As indicated in the above section, Bahmani-Oskooee has conducted 
similar work for all the largest US trading partners, with similar resu lts (strong suspicion of short-term 
effects, more ambiguous results in the long-run), with the latest study applying to US-Malaysia trade (Bahmani-Oskooee and Hanafiah, 2011).  Caglayan and Di (2010) examined the effect of real 
exchange rate volatility and sectoral trade between  the United States and its top thirteen trading 
partners. Unlike most of the previously mentioned studies, they conclude that exchange rate volatility 
does not systematically affect sectoral trade flows. Furthermore, any negative effects of exchange rate 
volatility, where they occur, often tend to be o ffset by opposite impacts of income volatility. 
III. OTHER PAPERS PROVIDED BY THE MEMBERS 
63. The other papers provided by Members give inte resting insights regarding the wider, perhaps 
less direct, channels linking the exchange rate, or ex change rate regimes, and trade. Two theoretical 
papers, one from Frenkel and R azin (1987), and one from Obstfeld (2001), looked at one of the 
leading explanatory models of the post-war ope n macroeconomics literature (the Mundell-Fleming 
model), to conclude that this model has lost a great deal of relevancy nowadays. The Mundell-
Fleming model analyses, inter alia, how the mobility  of international capital movements (and related 
openness to these movements) affects the effec tiveness of domestic macroeconomic policies under 
alternative (fixed and flexible) exchange rate re gimes. Obstfeld points to weaknesses in some the WT/WGTDF/W/57 
Page 18  
 
model's basic assumptions, for example that flexible  prices and highly integrated markets are hardly 
observable in reality, and that the existence of market segmentation blurs some of the model's 
conclusions. Frenkel and Razin point to other limita tions of the model, in particular that it ignores 
inter-temporal budget constraints and that it do es not include economic agents' expectations. 
64. A related paper is that of Chinn and Wei (2008) , which examined whether flexible exchange 
rate regimes have eased - as would have concl uded the Mundell-Fleming model - current account 
adjustments. They analysed data for 170 economi es in the period 1971-2005. They found no evidence 
to support this claim, which was fairly popular durin g the late 60's and early 70's. According to their 
findings, the nature of the nominal exchange rate regime has little influence on real exchange rate 
adjustment, with the parameter exerting the strongest influence on the current account.  
65. A number of papers made the point that the trade characteristics, structure and policy regime 
of a given country influence the way exchange rates impact trade. Kyriacou and Papageorghiou 
(2010), from the Central Bank of Cyprus, looked at the experience of their country in the run-up to the 
accession to the euro. According to them, a small open economy with high import content, such as 
Cyprus, had no interest in letting the exchange rate depreciate. Indeed, given the inelastic structure of 
imports, exchange rate depreciations would only lead  to inflation, and a loss, not a gain, in market 
shares. For these reasons, the adoption of the euro was not found to be a constraint.  
66. Li (2003) analysed the link between trade liber alization and exchange rate movements. He 
explained that in theory, trade liberalization should  lead to a decrease in the relative prices of imports 
and to an increase in the relative prices of exports  in relation to non-tradable goods. If as a result of 
this process, domestic prices fall below world prices, th e real exchange rate would tend to depreciate. 
He tested this hypothesis for a panel of 45 developi ng countries and found that the real exchange rates 
of countries having liberalized trade the most in a short period of time were also those that had 
depreciated the most. At the same time, he found that countries with multiple liberalization episodes 
over time tended to see their currencies appreciate in real terms.   
67. The wide differences of import and export price elasticities and the high degree of 
heterogeneity among countries, with varying eff ects on exchange rate adjustments, is further 
discussed by Imbs and Méjean (2010). In their paper,  they provide calculations of the price elasticities 
of imports and exports for 30 de veloped and developing countries accounting for 85 per cent of world 
trade, considering data for manufactured goods be tween 1995 and 2004. The authors recognized that 
export elasticities are fairly large, ranging from 1. 43 to 5.21. Developed c ountries tended to have 
lower values while developing countries had highe r ones, although countries such as China (2.836) 
and India (2.610) had export elasticities close to t hose of OECD countries, such as the United States 
(2.944), France (2.894) and the UK (2.654). 
68. Bauman (2010) studied whether regional production networks, in conjunction with 
preferential regional trade agreements, could ge nerate ‘regional demand multipliers’ by fostering 
competitiveness and regional economic convergence. They looked at regional experiences in South 
Asia, East Asia, Central America, Andean Count ries and Mercosur, between 1992 and 2008. For each 
region, the authors defined a ‘hub’ country, whose business cycle seemed to affect the activity of the 
other neighbouring economies. They chose Argentina, Brazil, China, India, Japan, Korea (Rep. of), 
and Mexico. According to their 'regional multiplie r' hypothesis, due to regional production chains, 
positive shocks in these 'hubs' provided a demand stimul us to the other regional economies, leading to 
a virtuous cycle for all the countries in the region, with the hub countries absorbing more imports from the other countries in the region. They found ev idence for this hypothesis in the case of East 
Asia, which has a share of regional trade of over 50 per cent (60 per cent of which denotes 
intermediate goods) and a high GDP convergence inde x. Latin America is the second region with the 
highest regional flows of intermediate goods and inputs, accounting for 20 per cent of its regional 
trade, although trade with the rest of the world re mains far more important than regional trade. GDP 
convergence, according to the author's definition, is also lower than in Asia. The authors argued that  WT/WGTDF/W/57 
 Page 19 
 
 
there are marked differences among sub-regions in  Latin America, with Mercosur presenting the 
highest (but still weak) signs of the 'regional multiplier' and Central America the lowest. Given that Latin America has grown significantly in the last few years, due to favourable conditions in the 
international market for commod ities, the authors argue that th is region faced a favourable 
conjuncture to evaluate how re gional economic relations could su stainably foster intra-regional 
competitiveness, in the face of competition from other regions such as East Asia. 
69. In this vein, the authors argue that a highe r volume of intra-regional trade and convergence 
could be achieved in Latin America by setting a sing le currency, and that dollarizing could be a first 
step towards that end. The Andean Community of Nations (2001) compiled a book of seven 
interventions made in the context of a Seminar on “Dollarization in Ecuador: Effects on the Andean 
Trade”, held in Lima on August 25th 2000. So me speakers argued that dollarization promoted 
macroeconomic stability and convergen ce, and reduced inflation, an old problem in the region. The 
Director General of the Andean Community of Nati ons' (CAN) Secretariat made the point that the de 
facto dollarization of Bolivia and Peru made sen se for the region. Other speakers underlined the 
challenges of dollarization.  First, while a common monetary zone could have positive 
macroeconomic effects on the region, it would re quire a very high level of coordination and 
convergence of economic policies.  Second, the domestic banking system had to be upgraded to 
sustain the capital inflows and outflows inherent to the adoption of the dollar as a currency. Moreover, 
it was argued that dollarization imposed a signifi cant upgrade of competitiveness in some fragile 
countries, resulting in a real appreciation of the ex change rate. This view is consistent with the 
findings of the paper by Astroga et al. (2003), who argued that as a result of dollarization in Ecuador, 
exchange rate appreciation contributed to the defici t in the trade balance to a level of 10 per cent of 
GDP. The authors proposed in return a contingent mechanism that would subject selected imports to 
safeguards to offset the depreciations of trading partners. 
70. The link between capital flows and the trade bala nce was mentioned, in particular, in Lane 
and Milesi-Ferretti (2002). Their paper provide empiri cal evidence of a positive long-run impact of a 
country’s net foreign assets position on real excha nge rate appreciation, taking into account OECD 
countries between 1970-1998. They decomposed this  relationship in two sub-components:  the 
relation between the net foreign asset position and th e trade balance; and the relationship between the 
trade balance and the real exchange rate. With rega rds to the first component, the authors found that 
the relation between the net foreign assets position and tr ade balance was driven by the rate of return 
differential between external assets and liabilities, and the growth rate of out put of each particular 
country. With regards to the second component, the au thors found that in the long-run, large trade 
deficits were associated with real exchange rates that had appreciated. They concluded by saying that 
the country size tended to increase the magnitude of th e trade balance effect on the real exchange rate.  
71. Some papers submitted by Members dealt with  the relationship between exchange rates, 
domestic macroeconomic policies and global imbalan ces. In a paper analysing previous episodes of 
global imbalances, Krugman (1987) argued that narrowing global imbalances would require not only 
a shift in demand from deficit to surplus countries, but also a real exchange rate adjustment. In 
particular, if world spending moved away from the United States, there would be an excess supply of 
goods produced in that country, which required a re lative price adjustment. Currency depreciation in 
the United States would solve the c oordination problem of changing all the relative prices at once, by 
lowering all domestic wages relative to foreign wages.  In a more recent paper, Rajan (2011) argued 
that global imbalances are the outcome of wrong domestic policies, overconsumption in developed 
countries, and over-exportation and savings in the largest emerging economies. "Fixing" currency 
policies would not be enough, and hence preventing a currency war should not be the main focus of 
international macroeconomic debates.  According to this author, the only sustainable solution to global 
imbalances was a demand shift from developed to em erging economies. To achieve this, and avoid an 
accompanying credit boom-and-bust cycle in the em erging countries, tougher regulation would be 
needed in the banking sector of all countries, particularly systemically important ones. In particular, emerging countries ought to discourage short-term foreign currency-denominated loans to their WT/WGTDF/W/57 
Page 20  
 
banking system. Moreover, Rajan claims that a more stable and less aggressive US monetary policy is 
needed to achieve a more sustainable US growth rate, and hence reduce the volatility of capital flows 
to emerging countries. Birdsall and Fukuyama ( 2011) argued that emerging economies should adopt 
an more inward-looking policy agenda, based on increased reliance on domestic demand, continued 
accumulation of foreign reserves, strengthened re gulation of the local banking sector, and lower 
reliance on the free flow of capital, asin the end su ch policies should help reduce global imbalances.  
72. Improved macroeconomic policy c oordination is often seen as a means of ensuring that the 
exchange rate does not hinder the expansion of in ternational trade. Kasa and Huh (2001) proposed a 
model according to which central banks have incentiv es to coordinate their exch ange rates in order to 
avoid competitive devaluations against one another, such as those that arose in the aftermath of the 
Great Depression of the 1930s.  In this respect, Eichengreen and Irwin (2009) analysed the policy 
reactions that originated in the 1930s in the f ace of the global downturn, and found that in the 1930s, 
the world economy suffered from different, inconsis tent and uncooperative economic policies, with 
some countries abandoning the gold standard while other kept it , leading the way for beggar-thy-
neighbour reactions. In the same vein, Ahamed ( 2011) argued that the global economy was unlikely to 
see a spiral of competitive devaluations similar to  the one that occurred during the Great Depression. 
His main arguments was that increased trade prot ection and competitive devaluations were not in 
countries' best interests in a world of global suppl y chains and production networks, where countries 
are far more dependent on imported inputs than any time in the past . In this respect, Busch and Levy 
(2010) provided a legal analysis of WTO provi sions if a currency case was brought to dispute 
settlement. They predicted that such a case would not be successful for the claimant although they 
argued that the WTO would constitute an important  forum for international dialogue and discussion 
regarding these issues.  
73. A few papers have discussed the choice of pa rticular currencies as transaction currencies in 
international trade. Using a theoretical model, Rey (2001) explained why there seems to be some 
inertia in the use of a specific international currency. Part of this inertia is linked to the fact that if 
multiple currencies are being used, higher tran saction costs would pass through to export prices. 
There is an incentive to use only one invoicing curr ency to maintain lower international prices and 
competitiveness. The currency of reference is cho sen according to the "thi ck market externality" 
principle, whereby the transaction costs of using a pa rticular currency in the market are reduced with 
market size. Therefore, the curre ncies of countries with large trad ing power, high le vels of openness 
and substantial bilateral trade flows are more lik ely to be chosen. Chandrasekhar (2010) argued that 
the resilience of the dollar as an international r eserve and transaction currency was based on overall 
US strength in international relati ons. He acknowledged that using alternative reserve currencies, such 
as IMF Special Drawing Rights (SDRs), presented problems on its own. For example, SDRs can only 
be used by governments and not by private entitie s in regular transactions. The author calls for a 
reform of the current financial architecture.   
IV. CONCLUSION 
74. Following the end of the Bretton-Woods system of  fixed but adjustable exchange rates four 
decades ago, the bulk of economic literature on th e relationship between ex change rates and trade 
deals with the effect of increased variability (volatility) of exchange rates on trade. This is almost 
exclusively the case until 2004, when the IMF survey was published.  This genre of the literature has 
continued until the present, incorporating improveme nts derived from theoretical refinements (the 
"new-new" trade theory) and new statistical inform ation (firm-level data). However, since the mid-
2000s the focus of the academic community has also turned towards the relationship between the level 
(misalignment) of exchange rates and trade.  
75. On the question of the effects of exchange rate  volatility on trade, the considerable array of 
theoretical and empirical literature  remains somewhat ambiguous.    As argued by Taglioni (2002), "it 
is customarily presumed that the adverse effect of ex change rate volatility (on trade flows), if it exists,  WT/WGTDF/W/57 
 Page 21 
 
 
is certainly not large". This conclusion is generally  shared by Ozturk (2006), which reveals a rather 
wide range of empirical evidence, some in fa vour and some against the hypothesis of a negative 
relationship between exchange rate  volatility and trade. As aptly summarized by Coric and Pugh 
(2010): "on average, exchange rate variability exerts a negative effect on international trade. Yet, […] 
this result is highly conditional. […] [A]verage trad e effects are not sufficiently robust to generalize 
across countries."  Results are conditional for a vari ety of reasons.  While exporting firms might in 
principle be more sensitive than domestic firms to ex change rate fluctuations, their sensitivity is likely 
to be reduced by a number of factors such as the existence of hedging instruments, the presence of 
imported inputs (which offset the effect of exch ange rate changes on the pricing of exports), the 
presence of firms on global markets (where upwards and downwards movements of various exchange 
rates cancel out), the possibility of invoicing in lo cal currency, and the capaci ty to absorb losses due 
to exchange rates changes and other factors in prof it margins.   The most sensitive firms may not be 
the large ones, but rather the smaller ones. In add ition, empirical studies tend to find a significant 
effect mainly in the case of trade with close neighbour s, in particular in the case of very integrated 
economies.  
76. On the issue of the level of exchange rates (m isalignments), theoretical and empirical studies 
over the years show that the relationship between th e level of a currency and trade is so multi-faceted 
and complex that it is hard to take a firm line in any particular direction. Economic theory suggests 
that when markets are free of distortions, an exch ange rate misalignment has no long-run effect on 
trade flows, as it does not change relative prices.  But long-run effects are predicted in models that 
assume market distortions, such as information problems or product market failures. In the short-run, 
when some prices in the economy can be sticky, movements in nominal exchange rates can alter 
relative prices and affect international trade flow s. These short-run trade effects, however, are not 
straightforward, as they are likely to depend on specific characteristics of the economy, including the currency in which domestic producers invoice their pr oducts and the structure of trade (for example, 
the prominence of global production networks). On  the empirical side, the complexity of the 
relationship between exchange rate  misalignments and trade yields mixed findings. For instance, a 
currency undervaluation is sometimes found to ha ve a positive impact on exports, but the presence, 
size and persistence of these effects are not consistent across different studies. 
  
 
 
    
 
     
 
    
 WT/WGTDF/W/57 
Page 22  
 
 
ANNEX I 
 
TABLE 1: 2006 SURVEY OF EMPIRICA L WORK ON THE RELATIONSHIP 
BETWEEN EXCHANGE RATES AND TRADE 
 
Study Sample 
Period Nominal or 
Real 
Exchange 
Rate Used Countries 
and 
Estimation 
Technique 
Used Main Result 
Akhtar and Hilton 
(1984)  1974-81Q  Nominal  OLS  Negative 
effect  
Gotur (1985)  1974-82Q  Nominal  OLS  Little to no 
effect  
Bailey, Tavlas 
and Ulan (1986)  1973-84Q  Nominal  OLS  Not 
significant, mixed effects  
Bailey, Tavlas 
and Ulan (1987)  1962-85Q  Nominal & 
Real  OLS  Little to no 
effect  
Bailey and Tavlas (1988)  1975-86Q  Nominal  OLS  Not 
significant  
Belenger et al. 
(1988)  1976-87Q  ---  IVE  Significant 
and negative in 2 sectors  
Brada and 
Mendez (1988)  1973-77A  Real  Cross section  Positive effect  
De Grauwe and 
Verfaille (1988)  1975-85A  Real  Cross section  Level of trade 
significantly stronger 
within EMS 
than outside the EMS 
Koray and 
Lastpares (1989) 1961-85M Real VAR Weak 
negative 
relationship 
Mann (1989) 1977-87Q Real OLS Few 
significant results 
Peree and Steinherr (1989) 1960-85A Nominal OLS Negative 
effect 
Caballero and 
Corbo (1989) -- Real OLS and IVE Significant 
and negative 
effect 
Lastrapes and Koray (1990) 1975-87Q Real VAR Weak 
relationship 
Medhora (1990) 1976-82A Nominal OLS Not 
significant and 
positive effect  WT/WGTDF/W/57 
 Page 23 
 
 
Study Sample 
Period Nominal or 
Real 
Exchange 
Rate Used Countries 
and 
Estimation 
Technique 
Used Main Result 
Asseery and Peel 
(1991) 1972-87Q Real OLS - ECM Significant 
and positive 
except for UK 
Bini – Smaghi (1991) 1976-84Q Nominal OLS Significant 
and negative 
effect 
Feenstra and Kendall (1991) 1975-88Q --- GARCH Negative 
effect 
Akhtar and Hilton 
(1991) 1974-81Q Nominal OLS Not 
significant, 
mixed effect 
Kumar and Dhawan 1974-85Q Nominal & 
Real  OLS Not 
significant and negative effect 
Belenger et al. (1992)  1975-87Q  Nominal  IVE, GIVE  Significant 
and negative 
effect  
Kumar (1992)  1962-87A  Real  Standard 
deviation  Mixed results  
Savvides (1992)  1973-86A  Real  Cross section  Negative 
effect  
Gagnon(1993)  Q  Real  Simulation 
analysis  Not 
significant  
Frankel and Wei (1993)  1980-90A  Nominal & 
Real  OLS and IVE  Small and 
negative in 1980, positive in 1990  
Kroner and Lastpares(1993)  1973-90M  Nominal  GARCH-M  Significant, 
varied signs and magnitudes  
Chowdhury(1993) 1973-90Q  Real  VAR  Significant 
negative effect  
Caporale and Dorodian (1994)  1974-92M  Real  Joint 
estimation  Significant 
negative effect  
McKenzie and Brooks (1997)  1973-92M  Nominal  OLS  Positive effect  
McKenzie (1998)      GARCH  Generally 
positive effect  
Daly (1998)  1978-92Q  Real    Mixed results  
Hook and Boon 
(2000)  1985-97Q  Both  VAR  Negative 
effect on 
export  
Aristotelous (2001)  1989-99A  Real  Gravity model No effect on 
export  WT/WGTDF/W/57 
Page 24  
 
Study Sample 
Period Nominal or 
Real 
Exchange 
Rate Used Countries 
and 
Estimation 
Technique 
Used Main Result 
Doganlar (2002)  1980-96Q  Real  EG Co-
integration  Negative 
effect on 
export  
Vergil (2002)  1990-2000Q  Real  Standard 
deviation  Negative 
effect on 
export  
Das (2003)  1980-2001Q  Both  ADF, ECM, 
Co-integration Significant 
negative effect 
on export  
Baak (2004)  1980-2002A  Real  OLS  Significant 
negative effect on export  
Tenreyro (2004)  1970-97A  Nominal  Gravity model Insignificant 
and no effect 
on trade  
Clark, Tamirisa, and Wei (2004)  1975-2000A  Both  Gravity model Negative and 
significant 
effect  
Kasman & Kasman (2005)  1982-2001Q  Real  Co-
integration, ECM  Significant 
positive effect on export  
Arize et al. (2005)  1973- Real  Co-
integration,  Significant 
negative 
impact  
Hwang and Lee (2005)  1990-2000M  Real  GARCH-M  Positive effect 
on import and 
insignificant effect on export  
Lee and Saucier 
(2005)  1986-2003Q  Nominal  ARCH-
GARCH  Negative 
effect on trade  
 
Source : Ozturk (2006)  WT/WGTDF/W/57 
 Page 25 
 
 
 
ANNEX II 
 
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