Exchange Rate Effects on the Volume and Variability of Trade Flows

Abstract

This paper investigates the effects of exchange rate uncertainty on the volume and variability of trade flows. Employing a signal extraction framework, we show that the direction and magnitude of importers' and exporters' optimal trading activities depend upon the source of the uncertainty (general economic shocks, fundamental factors driving the exchange rate process, or noise in the signal of policy innovations), providing a rationale for the contradictory empirical evidence in the literature. We also show that exchange rate uncertainty emanating from general economic shocks and the fundamental factors reduces the variability of trade flows, while that related to noise in the signal of policy innovations increases variability.