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Trade, Interdependence and Exchange Rates

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  • Fitzgerald, Doireann
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    Abstract

    The empirical “gravity†equation is extremely successful in explaining bilateral trade. This paper shows how a multi-country model of specialization and costly trade (i.e. a microfounded gravity model) can be applied to explain empirical exchange rate puzzles. One such puzzle is the fact that nominal exchange rates are enormously volatile, but that this volatility does not appear to affect inflation. The gravity model is very successful in explaining this puzzle. In a sample of 25 OECD countries in the post- Bretton Woods period, the gravity prediction of inflation substantially outperforms the purchasing power parity prediction. The gravity prediction matches the volatility of actual inflation, and tracks its path closely. The superior performance of the gravity prediction is explained primarily by the fact that it takes account of the interaction of specialization with home bias. The stability of inflation in very open economies is explained in addition by the fact that the size of bilateral trade is negatively correlated with bilateral exchange rate volatility.

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    Bibliographic Info

    Paper provided by Department of Economics, UC Santa Cruz in its series Santa Cruz Department of Economics, Working Paper Series with number qt4794h3b1.

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    Date of creation: 01 Nov 2004
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    Handle: RePEc:cdl:ucscec:qt4794h3b1

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    Keywords: Exchange rate disconnect; Trade; Gravity equation;

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    1. Ghironi, Fabio & Melitz, Marc, 2005. "International Trade and Macroeconomic Dynamics with Heterogeneous Firms," Scholarly Articles, Harvard University Department of Economics 3228377, Harvard University Department of Economics.
    2. Maurice Obstfeld & Kenneth Rogoff, 2001. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," NBER Chapters, National Bureau of Economic Research, Inc, in: NBER Macroeconomics Annual 2000, Volume 15, pages 339-412 National Bureau of Economic Research, Inc.
    3. Jeffrey A. Frankel & Shang-Jin Wei, 1993. "Emerging Currency Blocs," NBER Working Papers, National Bureau of Economic Research, Inc 4335, National Bureau of Economic Research, Inc.
    4. Ariel T. Burstein & Joao C. Neves & Sergio Rebelo, 2000. "Distribution Costs and Real Exchange Rate Dynamics During Exchange-Rate-Based-Stabilizations," NBER Working Papers, National Bureau of Economic Research, Inc 7862, National Bureau of Economic Research, Inc.
    5. Engel, C., 1996. "Accounting for U.S. Real Exchange Rate Changes," Discussion Papers in Economics at the University of Washington, Department of Economics at the University of Washington 96-02, Department of Economics at the University of Washington.
    6. Charles Engel & John H. Rogers, 1995. "Regional Patterns in the Law of One Price: The Roles of Geography vs. Currencies," NBER Working Papers, National Bureau of Economic Research, Inc 5395, National Bureau of Economic Research, Inc.
    7. José Manuel Campa & Linda S. Goldberg, 2005. "Exchange Rate Pass-Through into Import Prices," The Review of Economics and Statistics, MIT Press, MIT Press, vol. 87(4), pages 679-690, November.
    8. Corsetti, Giancarlo & Dedola, Luca, 2002. "Macroeconomics of international price discrimination," Working Paper Series, European Central Bank 0176, European Central Bank.
    9. Philip R. Lane & Patrick Honohan, 2003. "Divergent Inflation Rates in EMU," Trinity Economics Papers, Trinity College Dublin, Department of Economics 20034, Trinity College Dublin, Department of Economics.
    10. Christian Broda & John Romalis, 2011. "Identifying the Relationship Between Trade and Exchange Rate Volatility," NBER Chapters, National Bureau of Economic Research, Inc, in: Commodity Prices and Markets, East Asia Seminar on Economics, Volume 20, pages 79-110 National Bureau of Economic Research, Inc.
    11. Paul R. Bergin & Reuven Glick, 2003. "Endogenous Tradability and Macroeconomic Implications," NBER Working Papers, National Bureau of Economic Research, Inc 9739, National Bureau of Economic Research, Inc.
    12. Jonathan Eaton & Samuel Kortum, 2002. "Technology, Geography, and Trade," Econometrica, Econometric Society, Econometric Society, vol. 70(5), pages 1741-1779, September.
    13. Papell, David H & Theodoridis, Hristos, 2001. "The Choice of Numeraire Currency in Panel Tests of Purchasing Power Parity," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 33(3), pages 790-803, August.
    14. Hau, Harald, 2002. "Real Exchange Rate Volatility and Economic Openness: Theory and Evidence," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 34(3), pages 611-30, August.
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