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Exchange rate variability and EU trade

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  • Khalid Sekkat

Abstract

The present study focuses on international trade. The aim is to construct a small econometric model allowing the evaluation of the impact of variability on European trade.The report is organised as follows. Section I offers a conceptual analysis of the impact of exchange rate variability on trade. Section II presents previous empirical findings for Europe. The theoretical model relating variability to trade is constructed and analysed in Section III, while Section IV presents the empirical analysis and discusses the major findings. Section V sets out the conclusions. II/051/98 Exchange rate variability is a central theme in the debate on the performance of exchange rate regimes. The consequences of this variability for economic activities have always been a major concern of policy makers. After World War II, the Bretton Woods agreements created the International Monetary Fund and set up a world-wide system of fixed exchange rates. One objective of this system was to foster international exchanges of goods and services.In 1973, the Bretton Woods system was abandoned and many countries allowed their exchange rates to float. The consequence was an increase in exchange rate variability. Hence, the debate on the optimal management of exchange rates attracted renewed attention. It was enhanced by the possibility of a causal link between this increased variability and the observed decline in the growth rate of trade. Advocates of a regime of fixed rates emphasised its merits in terms of co-ordination, discipline and credibility of economic policies, as well as its role in stimulating international trade. The supporters of flexibility put forward its advantages in terms of increased autonomy in pursuing domestic policy objectives.In Europe, policy makers seemed to have been much more convinced by the merits of a regime of fixed rates. In 1972, they created the Snake, a system of fixed exchange rates among member countries. The Snake experienced a number of realignments and the entry and exit of various member countries, which substantially weakened its credibility. A new system of fixed rates was therefore set up in 1979 : the Exchange Rate Mechanism of the European Monetary System (the ERM of the EMS). Despite several realignments during the early eighties, the ERM has succeeded in stabilising exchange rates between member countries. After 1983, realignments become smaller and rarer, and between 1987 and 1992 there was almost no realignment. The stable environment (with respect to exchange rates) during the period 1987-1992 was favourable to the concept of creating Economic and Monetary Union (EMU) in Europe. Some economists argued that the move to EMU should pose no problems because within the ERM, realignments were no longer needed.To illustrate the European experience with exchange rate management, Figure 1 presents the variability of the nominal effective exchange rates (NEER) of four currencies (those of Belgium, Germany, France and Italy) between 1970 and 1995. The variability is computed as the yearly standard deviation of monthly percentage changes in nominal effective exchange rates. Comparing the pre-ERM period to the ERM period, it appears that member countries experienced lower variability in the ERM period. Even during the ERM crisis in the early 1990s, variability is lower than during the pre-ERM period for member countries. The most stable period is clearly 1987-1991. Figure 1 shows that during the ERM period, a non-member country (i.e. the UK) experienced a significantly higher level of variability than the ERM countries . Hence, the ERM may clearly be credited for having reduced exchange variability among participating countries.An abundant empirical literature has analysed the recent European experience of fixed exchange rates. The conclusions of such analyses are of prime importance when examining the potential impact of EMU in Europe. The analyses investigate various aspects of the ERM experience : transmission of shocks, nominal and real convergence, policy co-ordination, international trade, etc.The present study focuses on international trade. The aim is to construct a small econometric model allowing the evaluation of the impact of variability on European trade.The report is organised as follows. Section I offers a conceptual analysis of the impact of exchange rate variability on trade. Section II presents previous empirical findings for Europe. The theoretical model relating variability to trade is constructed and analysed in Section III, while Section IV presents the empirical analysis and discusses the major findings. Section V sets out the conclusions.

Suggested Citation

  • Khalid Sekkat, 1998. "Exchange rate variability and EU trade," European Economy - Economic Papers 2008 - 2015 127, Directorate General Economic and Financial Affairs (DG ECFIN), European Commission.
  • Handle: RePEc:euf:ecopap:0127
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    Cited by:

    1. Honohan, Patrick & Lane, Philip R, 1999. "Pegging to the Dollar and the Euro," International Finance, Wiley Blackwell, vol. 2(3), pages 379-410, November.
    2. Ramos, Raul & Clar, Miquel & Suriñach, Jordi, 2000. "Trade And Exchange Rate Variability: New Evidence From Eu Countries," ERSA conference papers ersa00p103, European Regional Science Association.
    3. Hochreiter, Eduard & Schmidt-Hebbel, Klaus & Winckler, Georg, 2002. "Monetary union: European lessons, Latin American prospects," The North American Journal of Economics and Finance, Elsevier, vol. 13(3), pages 297-321, December.
    4. Tenreyro, Silvana, 2007. "On the trade impact of nominal exchange rate volatility," Journal of Development Economics, Elsevier, vol. 82(2), pages 485-508, March.
    5. Michel Fouquin & Nanno Mulder & Laurence Nayman & Khalid Sekkat & Joffrey Malek Mansour, 2001. "Sector Sensitivity to Exchange Rate Fluctuations," Working Papers 2001-11, CEPII research center.
    6. Ansgar Belke & Daniel Gros, 1999. "Estimating the costs and benefits of EMU: The impact of external shocks on labour markets," Review of World Economics (Weltwirtschaftliches Archiv), Springer;Institut für Weltwirtschaft (Kiel Institute for the World Economy), vol. 135(1), pages 1-47, March.
    7. Attila Csajbók (ed.) & Ágnes Csermely (ed.), 2002. "Adopting the euro in Hungary: expected costs, benefits and timing," MNB Occasional Papers 2002/24, Magyar Nemzeti Bank (Central Bank of Hungary).
    8. Olimov, Ulugbek & Sirajiddinov, Nishanbay, 2008. "The Effects of the Real Exchange Rate Volatility and Misalignments on Foreign Trade Flows in Uzbekistan," MPRA Paper 9749, University Library of Munich, Germany.
    9. Agnès Bénassy-Quéré & Amina Lahrèche-Revil, 2003. "Trade Linkages and Exchange Rates in Asia: The Role of China," Working Papers 2003-21, CEPII research center.
    10. Paul Grauwe & Frauke Skudelny, 2000. "The impact of EMU on trade flows," Review of World Economics (Weltwirtschaftliches Archiv), Springer;Institut für Weltwirtschaft (Kiel Institute for the World Economy), vol. 136(3), pages 381-402, September.
    11. Khalid Sekkat, 2001. "On the Aggregate Impact of Exchange Rate Variability on EU Trade," German Economic Review, Verein für Socialpolitik, vol. 2(1), pages 57-78, February.
    12. Lionel Fontagné & Michael Freudenberg, 1999. "Endogenous Symmetry of Shocks in a Monetary Union," Open Economies Review, Springer, vol. 10(3), pages 263-287, July.

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    Keywords

    bretton woods; exchange rates; trade;

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