Does Exchange Rate Stability Increase Trade and Capital Flows?

Many economists and policy-makers believe that a stable exchange rate fosters trade in goods and movement of capital: the 1990 European Community report 'One Market, One Money' describes increased trade and capital market integration as one of the main benefits of adopting a single currency in Europe. But despite this widespread view, the substantial empirical literature examining the link between exchange rate uncertainty and trade has not found a consistent relationship. Even in those papers that do find a negative relationship, it is generally weak. This discrepancy between the conventional wisdom and the empirical evidence calls into question the framework used to think about these issues. In particular, these questions have not been cast in a macroeconomic, general equilibrium framework. 

In a recent Discussion Paper, Philippe Bacchetta and Eric van Wincoop develop a benchmark model that allows them to capture the main mechanisms through which the exchange rate regime can affect trade and capital flows. Two factors play a central role in their analysis: a general equilibrium framework and a deviation from purchasing power parity (PPP). Most open economy models do not contain these two ingredients. While there exists a literature that investigates the impact of exchange rate uncertainty on trade flows, it generally adopts a partial equilibrium approach. In these types of model exchange rate uncertainty is usually exogenous in an environment that is otherwise deterministic. Those models that do take a general equilibrium approach commonly adopt the PPP assumption, so that the real exchange rate is constant.

The case for using a general equilibrium framework is obvious, since the exchange rate cannot be examined in isolation. There is now a substantial body of literature showing a close relationship between exchange rates and easily observable fundamentals at horizons of at least one year. The same fundamentals that drive exchange rate fluctuations (e.g. monetary, fiscal and productivity shocks) affect the overall macroeconomic risks faced by firms and households. Given the large observed fluctuations in real exchange rates, the case for allowing deviations from PPP should also be obvious. The law of one price is grossly violated even for traded goods, and deviations from the law of one price are closely related to nominal exchange rate volatility.

Recently, a 'New Open Economy Macroeconomics' literature has emerged and progress has been made towards developing general equilibrium models that capture some of the key stylized facts about exchange rates. A now popular approach is to assume pricing to market in conjunction with Keynesian price rigidity. Under this assumption markets are segmented so that there is no arbitrage. Firms set their prices before the exchange rate is known and are able to price discriminate between domestic and foreign markets. A change in the exchange rate will then directly affect the price of a good in one country relative to that in another country. This results in a close relationship between nominal and real exchange rates.

An important hypothesis underlying much of the previous literature is the idea that the exchange rate is the only source of uncertainty. However, firms typically face other sources of risk – although these are potentially correlated with exchange rate fluctuations. If exchange rates are related to fundamentals, then the same variables that drive fluctuations in the exchange rate are also responsible for uncertainty about the wage rate, the level of aggregate demand, and technology. Thus, in order to understand the implications of different exchange rate regimes for price setting and trade flows, the authors assess the overall macroeconomic risks that firms face. For this purpose, they extend the 'New Open Economy Macroeconomics' literature in several directions.

In the benchmark model the authors consider the case where uncertainty comes only from stochastic monetary shocks. They develop a two-country general equilibrium model with price rigidity and pricing to market. The world is composed of households, firms and a government in each country. Households decide their optimal level of consumption, labour supply and money holdings, where money is held through a simple cash-in-advance constraint. Each government provides random money transfers to its residents. And trade takes place as a result of monopolistic competition in differentiated goods. In particular, they initially consider only a one-period version of the model, do not allow for capital accumulation, and assume utility is separable in consumption and leisure.

A crucial channel for the impact of the exchange rate regime is the price-setting behaviour of firms. Firms set their price in both markets (home and abroad) before the uncertainty about either country's money supply is resolved. They do not change their prices after becoming aware of each country's money supply because this would be too costly. Owing to the symmetric structure of the model, the nominal exchange rate is equal to the ratio of the two countries' money supplies. Although this is clearly a very simplistic exchange rate equation, it captures the basic idea that the exchange rate is connected to underlying fundamentals, thus illustrating the importance of the general equilibrium analysis. Hence, uncertainty about the fundamentals (i.e. the money supplies) not only leads to uncertainty about the exchange rate firms face, but also about the wages they pay and the demand for their goods.  

By comparing prices and trade flows under both fixed and floating exchange rates, the authors show that in a world of only monetary shocks trade is not necessarily higher under a fixed exchange rate system. In the benchmark model the level of trade is unaffected by the type of exchange rate regime when utility is separable in consumption and leisure. This finding is consistent with conclusions that have been drawn from the empirical literature. If the assumption that utility is separable in consumption and leisure is dropped then trade is found to be higher (lower) under a flexible than under a fixed exchange rate system when consumption and leisure are compliments (substitutes).

In a partial equilibrium analysis the above result would have been very different. In a general equilibrium framework, the monetary shocks that drive the exchange rate fluctuations also lead to uncertainty about wages and the quantity of goods sold, both of which affect total labour costs. Hence, even though the exchange rate is more volatile under a flexible regime, the movements in it are offset by relative demand shocks. In addition, the shocks to costs perceived by firms are the same under both types of system.

Bacchetta and van Wincoop extend their benchmark model in a number of ways. First, they include productivity and government spending shocks. Again, preferences are assumed to be separable in consumption and leisure. The inclusion of these types of shock results in lower trade under a floating regime when macroeconomic policy is used to exert a stabilizing role in the home market. Second, the model is extended so that agents trade assets before the uncertainty about the money supply in each country is resolved. None of the above findings are qualitatively affected by the inclusion or structure of an international asset market. This stems from the deviation from PPP, which makes it impossible to equate consumption across countries in all states of the world – i.e. to obtain full insurance. Thus, the presence of complete asset markets cannot eliminate risk.

Finally, the authors develop a two-period version of the model in order to examine the effects that different exchange rate regimes have on the size of net capital flows. They find that the flows tend to be lower under a floating regime when there is a preference for domestic bonds. This prediction is consistent with the high correlation that is observed between domestic saving and investment rates. There is also some preliminary empirical evidence that net capital flows may be negatively affected by exchange rate volatility.

Discussion Paper No.1962: 'Does Exchange Rate Stability Increase Trade and Capital Flows?' by Philippe Bacchetta (Studienzentrum Gerzensee, Université de Lausanne, and CEPR) and Eric van Wincoop (Federal Reserve Bank of New York).