The exchange rate regime can affect both the volume of trade and its process of adjustment to exchange rate changes, and recent research on dynamic imperfect competition has shown that concerns about market shares may prevent exchange rate movements from passing through into trade prices. In Discussion Paper No. 810, Research Fellow André Sapir and Khalid Sekkat examine whether firms price differently in response to exchange rate changes for trade inside and outside the ERM area. This will have implications for whether the ERM reduced exchange rate misalignments, enhanced expectations of exchange rate stability and thus improved the process of trade adjustment, or whether this might have occurred under flexible rates.

In their two-period model of duopoly competition with differentiated products, switching costs cause second-period demands to depend on first-period market shares, which also reflect agents' subjective expectations of exchange rate changes by the second period. Sapir and Sekkat measure exporters' perception of exchange rate stability by regressing import price series for intra- and extra-ERM trade flows during the 1980s for six industrial sectors on market shares, production costs, exchange rates and the interest rate differential. Coefficients on the latter indicate exporters' perceptions of exchange rate stability, and their results confirm that the EMS reduced misalignments and thus enhanced trade adjustment during the 1980s. Detailed investigation of the non-ERM sample (covering trade with the UK, US and Japan) reveals, however, that flexible rates need not handicap adjustment, and the lack of adjustment in the 1980s reflected the exceptional misalignment associated with mismanagement of the dollar. This suggests that a system of pegged rates is helpful but not necessary to smooth trade adjustment, since it is the absence of misalignment rather than the choice of exchange rate regime that is critical in fulfilling this objective.

Exchange Rate Regimes and Trade Prices: Does the EMS Matter?
André Sapir and Khalid Sekkat

Discussion Paper No. 810, August 1993 (IM/IT)