Exchange rates have experienced large and frequent fluctuations during the floating exchange rate period, but the response of trade flows and current accounts to these fluctuations has been rather limited. This persistence of trade imbalances, in particular between Germany, Japan and the US, and their apparent unresponsiveness to exchange rate changes has led to a re-examination of the traditional adjustment processes. In Discussion Paper No. 1352, Research Fellow Giorgia Giovannetti and Hossein Samiei examine the issue from an econometric point of view by distinguishing two types of hysteresis; one arising from limited exchange rate pass-through (or pricing-to-market) and another arising from regime switches in supply.

Pricing-to-market occurs when firms, rather than passing on exchange rate changes to export prices, try to hold onto their market shares by keeping prices stable in the importing country’s currency. Hysteresis in supply implies that the market lost when a country’s currency appreciates, may not necessarily be regained when the currency returns to its original level. Moreover, markets entered in order to exploit a temporary exchange rate movement are not immediately abandoned when the profit opportunities disappear.

They develop an econometric model of export determination where the presence of sunk costs causes discontinuous behaviour and hysteresis so that an individual exporter’s decision to stay in or out of the market depends on the current value of the exchange rate as well as its past history. The aggregate level of exports is then determined by the proportion of exporters that stay in the market. The resulting non-linear model is estimated using data on manufacturing exports for Germany, Japan and the United States. The paper finds strong evidence in favour of the presence of pricing-to-market and hysteresis only in the case of Japanese exports.