A long-established explanation for the deceleration in international trade growth, dating back to the breakdown of the Bretton Woods system in the early 1970s and the resulting move to freely floating exchange rates, refers to the volatility of flexible exchange rates. Since volatility is associated with increased risk following an unexpected variation in the exchange rate, risk-averse exporters would reduce their output in response to higher exchange rate volatility. From this point of view, the extent of exchange rate volatility might be a relevant factor in explaining the decrease in the growth of international trade in recent years.
However, there is no consensus among economists regarding how exchange rate volatility affects foreign trade volume. According to the proponents of fixed exchange rates, floating rates are subject to excessive volatility, and deviations from equilibrium rate (i.e., the so called exchange rate misalignments) may become permanent in time. Accordingly, exchange rate volatility would affect realized profits and reduce foreign trade volume, since most trade contracts are in the currency of either the importing or exporting country.
On the other hand, some authors assert that exchange rate volatility might raise the volume of foreign trade, which could be justified on several grounds. For instance, even for risk-averse exporters, a higher risk does not necessarily involve a decline in risky activities. Also, the availability of hedging techniques allows exporters to avoid exchange rate risk at a small cost. In addition, exchange rate volatility may bring about some profitable trade opportunities.
Our aim in this paper will be to examine the extent to which exchange rate volatility might account for the drop in the rate of growth of exports in the EU and, in particular, the eurozone, since the beginning of the crisis. In the empirical application, we will estimate an export function, augmented to include several measures of exchange rate volatility, for the four largest economies of the eurozone, namely, France, Germany, Italy and Spain.
JEL codes: F31, F41, F45
Keywords: Exchange rate volatility; Exports; Eurozone