2.2.2 that the volume of international trade in

2.2.2 EXCHANGE RATE
THEORIES

Prior to the monetary-approach
emphasis of the 1970s, it was common to emphasize international trade flows as
primary determinants of exchange rates. This was due, in part, to the fact that
governments maintained tight restrictions on international flows of financial
capital. The role of exchange rate changes in eliminating international trade
imbalances suggests that we should expect countries with current trade
surpluses to have an appreciating currency, whereas countries with trade
deficits should have depreciating currencies. Such exchange rate changes would
lead to changes in international relative prices that would work to eliminate
the trade imbalance.

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In recent years, it has become clear
that the world does not work in the simple way just considered. For instance,
with financial liberalization we have seen that the volume of international
trade in financial assets now dwarfs trade in goods and services. Moreover, we
have seen some instances where countries with trade surpluses have depreciating
currencies, whereas countries with trade deficits have appreciating currencies.
Economists have responded to such real-world events by devising several
alternative views of exchange rate determination. These theories place a much
greater emphasis on the role of the exchange rate as one of many prices in the worldwide
market for financial assets.

 

The Asset Approach

Modern exchange rate models emphasize financial-asset markets.
Rather than the traditional view of exchange rates adjusting to equilibrate
international trade in goods, the exchange rate is viewed as adjusting to
equilibrate international trade in financial assets. Because goods prices
adjust slowly relative to financial asset prices and financial assets are
traded continuously each business day, the shift in emphasis from ‘goods
markets’ to ‘asset markets’ has important implications. Exchange rates will
change every day or even every minute as supplies of and demands for financial assets
of different nations change. An implication of the asset approach is that
exchange rates should be much more variable than goods prices. This seems to be
an empirical fact. Exchange rate models emphasizing financial-asset markets
typically assume perfect capital mobility. In other words, capital flows freely
between nations as there are no significant transactions costs or capital
controls to serve as barriers to investment (Isard Peter, 1995).

 

Sterilization Approach

In recent years, an important topic
of debate has emerged from the literature on the monetary approach regarding
the ability of central banks to sterilize reserve flows. ‘Sterilization’ refers
to central banks offsetting international reserve flows to follow an independent
monetary policy.

The use of the word ‘sterilization’ is
due to the fact that the central bank must be able to neutralize, or sterilize,
any reserve flows induced by monetary policy if the policy is to achieve the
central bank’s money-supply goals. For instance, if the central bank is
following some money-supply growth path and then money demand increases,
leading to reserve inflows, the central bank must be able to sterilize these reserve
inflows to keep the money supply from rising to what it considers undesirable
levels. This is done by decreasing domestic credit by an amount equal to the growth
of international reserves, thus keeping base money and the money supply constant.
(Isard Peter, 1995).

 

2.3 Empirical
Literature Review

The empirical relationship between exchange rate, its volatility
and trade performance has been discussed and analyzed in various studies both
for developed and developing countries. Several empirical works have been
provided on the impact of exchange rate volatility on international trade;
however there is a dearth of work on its persistence on trade balance. The
general observation from these studies is that results have been inconclusive
and mixed due to factors such as differences in sample periods, methodology
adopted, estimation techniques and the countries considered (developed or
developing).

 

In the international context, Akhtar
and Hilton (1984) studied the effects of exchange rate uncertainty on German
and US trade. Price and volume equations for aggregate exports and imports of manufactured
goods were estimated for the two countries using quarterly observations from
1974 to 1986. The variables employed included; the level of foreign income (YF),
the relative price of export goods to foreign substitutes in foreign currency
terms (RELPX), and capacity utilization abroad (CUF) – for the export volume
(QX) equations, while import volume was specified as a function of domestic
income (YD), the relative price of import goods to domestic substitutes in
domestic currency terms (RELPM), and the ratio of foreign to domestic capacity
utilization (CUFCU). The measure of exchange rate variability used was the
standard deviation over a three month period of a daily effective exchange rate
index. Their result showed that exchange rate uncertainty has a significant
adverse impact on imports and exports of Germany and of the US.

 

Also, De Grauwe and Verfaille (1988)
in their study ‘Exchange rate variability, misalignment, and the european monetary
system’ performed a cross-section analysis on the average yearly change of the
volume of exports during the period 1979 – 1985. The sample included the
bilateral exports of 15 industrial countries which together constitute more
than 90 percent of trade among industrial countries. The econometric model was
specified using the following variables – exports (X), real income (Y), the
bilateral real exchange rate (R), trade openness (T), real exchange rate
variability (S), and protectionist pressure created by misalignment (M). While
adopting the standard deviation, they found out that exchange rate variability
and misalignment have a negative effect on international trade.