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Trade, Interdependence and Exchange Rates

  • Fitzgerald, Doireann

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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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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  1. Maurice Obstfeld & Kenneth Rogoff, 2001. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," NBER Chapters, in: NBER Macroeconomics Annual 2000, Volume 15, pages 339-412 National Bureau of Economic Research, Inc.
  2. Ghironi, Fabio & Melitz, Marc, 2005. "International Trade and Macroeconomic Dynamics with Heterogeneous Firms," Scholarly Articles 3228377, Harvard University Department of Economics.
  3. José Manuel Campa & Linda S. Goldberg, 2005. "Exchange Rate Pass-Through into Import Prices," The Review of Economics and Statistics, MIT Press, vol. 87(4), pages 679-690, November.
  4. Giancarlo Corsetti & Luca Dedola, 2002. "Macroeconomics of international price discrimination," International Finance Discussion Papers 744, Board of Governors of the Federal Reserve System (U.S.).
  5. Engel, C. & Rogers, J.H., 1996. "Regional Patterns in the Law of One Price: The Roles of Geography vs. Currencies," Working Papers 96-01, University of Washington, Department of Economics.
  6. Patrick Honohan & Philip R. Lane, 2003. "Divergent inflation rates in EMU," Economic Policy, CEPR;CES;MSH, vol. 18(37), pages 357-394, October.
  7. 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, vol. 33(3), pages 790-803, August.
  8. Jeffrey A. Frankel & Shang-Jin Wei, 1993. "Emerging Currency Blocs," NBER Working Papers 4335, National Bureau of Economic Research, Inc.
  9. Burstein, Ariel Tomas & Neves, Joao C & Rebelo, Sérgio, 2001. "Distribution Costs and Real Exchange Rate Dynamics During Exchange-Rate-Based Stabilization," CEPR Discussion Papers 2944, C.E.P.R. Discussion Papers.
  10. Jonathan Eaton & Samuel Kortum, 2002. "Technology, Geography, and Trade," Econometrica, Econometric Society, vol. 70(5), pages 1741-1779, September.
  11. Paul Bergin & Reuven Glick, 2005. "Endogenous Tradability andMacroeconomic Implications," Working Papers 513, University of California, Davis, Department of Economics.
  12. Charles Engel, 1999. "Accounting for U.S. Real Exchange Rate Changes," Journal of Political Economy, University of Chicago Press, vol. 107(3), pages 507-538, June.
  13. Hau, Harald, 2000. "Real Exchange Rate Volatility and Economic Openness: Theory and Evidence," CEPR Discussion Papers 2356, C.E.P.R. Discussion Papers.
  14. Christian Broda & John Romalis, 2011. "Identifying the Relationship Between Trade and Exchange Rate Volatility," NBER Chapters, in: Commodity Prices and Markets, East Asia Seminar on Economics, Volume 20, pages 79-110 National Bureau of Economic Research, Inc.
  15. Philip R. Lane & Patrick Honohan, 2003. "Divergent Inflation Rates in EMU," Trinity Economics Papers 20034, Trinity College Dublin, Department of Economics.
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