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A Framework to Analyze the Impact of Exchange Rate: Uncertainty on Output Decisions

  • Gonzalo Varela

    ()

    (Department of Economics, University of Sussex)

Southern Cone economies exhibit a high record of exchange rate volatility. In this context, rms tend to contract dollar debt, irrespective of their trade orientation, and without available hedging instruments. This exposes them to bankruptcy risk, in the event of large exchange rate movements. This paper provides a framework to analyze the output e ect of exchange rate uncertainty in that context, by focusing on the channel uncertainty-output that operates through the nancial strategy of the rm. We nd that increases in exchange rate uncertainty increase the probability of bankruptcy, thus increasing expected marginal bankruptcy costs, and reducing optimal output of a risk-neutral rm. Furthermore, we nd that rms with higher than average liquidity balances will face lower marginal bankruptcy costs, thus producing more than the average rm. The model displays persistence, as any shock to current pro ts a ects future liquidity balances, and so, future output. This framework can easily be extended to explain the response of other rms' decisions to exchange rate uncertainty, such as investment.

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Paper provided by Department of Economics, University of Sussex in its series Working Paper Series with number 2411.

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Date of creation: Aug 2011
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Handle: RePEc:sus:susewp:2411
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  1. Warner, Jerold B, 1977. "Bankruptcy Costs: Some Evidence," Journal of Finance, American Finance Association, vol. 32(2), pages 337-47, May.
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