Using a Vector Autoregressions (VAR) approach, this article investigates the impact of nominal exchange
rate volatility on India’s bilateral import from USA during March 1992 to April 2002. The major findings
of the study are (i) exchange rate volatility affects the volume of imports negatively during the period. (ii)
However, volatility of nominal effective exchange rates loses its explanatory power in explaining the changes
in import volume in the presence of relevant macroeconomic variables such as GDP, exchange rate and terms
of trade. (iii) It is also seen that GDP affects import more than volatility of nominal effective exchange rate,
exchange rate and terms of trade.
Since the breakdown of the Bretton Woods Agreement in 1973, a debate began in economic
circles about the impact of exchange rate volatility on volume of international trade. As
there have been major developments in the world economy since then, it is appropriate to
examine the relationship between exchange rate volatility and trade flows, which has
thrived recently. Some of the developments appear to the exacerbated fluctuations in
exchange rates. Events like the liberalization of capital flows in the last two decades, the
enormous increase in the scale of cross-border financial transactions and the breakup of the
former Soviet Union, all tended to be associated with increasing exchange rate movements.
Currency crises in emerging market economics are special examples of high exchange rate
volatility. In addition, the transition to market-based system in central and Eastern Europe
often involves major adjustments in the international value of these economies’ currencies.
All these factors may in turn adversely disturb all the macroeconomic variables and the
structure of the economy.
The extent to which exchange rate volatility affects the volume
of trade is an empirical question. However, despite a large body of literature on this issue,
no consensus has emerged thus far. For example, Chowdhury (1993) and Caporale and
Doroodian (1994), Arize et al. (2000), and De Grauwe and Skudelny (2000) show
consistently adverse consequence of exchange rate volatility on trade flows. Ethier (1973),
Brodsky (1984) and Ganon (1993), suggested that exchange rate volatility might reduce
trade flows. Their argument is that exchange rate volatility increases the risk in foreign
trade, which will ultimately lead the risk averse traders to reduce trade volumes, particularly
where appropriate hedging facilities do not exist, or are costly. On the other hand, Franke
(1991), Sercu (1992), and Sercu and Vehulle (1992), claim that exchange rate volatility
affects international trade positively since firms, on an average, enter a market sooner and
exit later when exchange rate volatility increases.
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