This paper investigates the direction of causality between exchange rate and trade (exports and imports) for a developing country like Pakistan, utilizing the monthly time series data covering the period 1995-2006. Cointegration and causality tests were conducted to assess the link between trade and exchange rate. The results of Johansen-Juselius (JJ) cointegration tests indicate that there is one cointegrating vector between exchange rate, exports and imports. However, an important finding of this empirical research is that there is a strong and stable relationship between exports and imports, and the causality is bidirectional. This study also rejects previous findings about negative effect of exchange rate volatility on trade volume in a developing economy like Pakistan.

The present study analyzes the relationship between exchange rate and trade (exports and imports) for a developing economy like Pakistan. Relevant literature documented substantial but contradictory evidence about the impact of exchange rate volatility on international trade. There are a number of studies that support the hypothesis that volatility of the exchange rate is negatively related with the volume of trade (Ethier, 1973; Hooper and Kohlhagen, 1978; Cushman, 1983, 1986 and 1988; Akhtar and Hilton, 1984; Kenen and Rodrick, 1986; Pere and Steinherr, 1989; Thursby and Thursby, 1987; DeGrauwe, 1988; Koray and Lastrapes, 1989; Kumar and Dhawan, 1991; Gagnon, 1993; Broll, 1994; Caporale and Dorodioon, 1994; Arize, 1995; Wolf, 1995; Dell'Ariccia, 1998; Rose, 2000; and Vergil, 2002). These studies support the idea behind the intuition that exchange rate volatility tends to reduce trade volume, because exchange rate volatility increases uncertainty which, in turn, decreases volume of trade. However, some studies found inconclusive impact of exchange rate volatility on exports growth of developing countries as they have explained variation in exchange rate policies and the level of growth (Rana, 1983; and Bahmani-Oskooee, 1984 and 1986). Such evidence further supports the view that there is an ambiguity in the role of exchange rate volatility on trade volume. Bahmani-Oskooee (1984 and 1986) found that exchange rate has a significant impact on trade flows of selected developing countries even in periods when most of them had pegged exchange rates. However, it is also found that exchange rate volatility or risk may actually stimulate trade flows since uncertainty is considered as an option held by firms, which increases profitability (DeGrauwe, 1988; Giovannini, 1988; Franke, 1991; and McKenzie and Brooks, 1997). Kroner and Lastrapes (1993), McKenzie (1998), Asseery and Peel (1991), and Aristotelous (2001) found no evidence of the impact of exchange rate volatility on trade.

Moccero and Winograd (2006) investigated the effect of exchange rate volatility by examining the intra and extra regional exports and concluded that reducing volatility has a positive impact on exports in Brazil, but a detrimental effect on exports to the rest of the world. There are a few studies which examined separately the negative effect of exchange rate volatility on imports; for example, Rana (1983) estimated the import demand function for various countries and concluded that the increase in exchange rate risk has a significant negative impact on import volumes. Gotur (1985) and Cushman (1986) also investigated the effect of exchange rate volatility on imports.

Applied Economics Journal, Exchange Rate Volatility, Empirical Analysis, International Financial Statistics, IFS, Error Correction Model, ECM, Schwarz Bayesian Criteria, SBC, Variance Decompositions, VDC, Standard Granger Causality, SGC, Augmented Dickey-Fuller, ADF.