Exchange rate effects on the volume and variability of trade flows

This paper investigates the effects of exchange rate uncertainty on the volume and variability of trade flows. Employing a signal extraction framework, we show that the direction and magnitude of importers' and exporters' optimal trading activities depend upon the source of the uncertainty (general microstructure shocks, fundamental factors driving the exchange rate process, or a noisy signal of policy innovations), providing a rationale for the contradictory empirical evidence in the literature. We also show that exchange rate uncertainty emanating from general microstructure shocks and the fundamental factors reduces the variability of trade flows, while that related to a noisy signal of policy innovations increases variability. (C) 2002 Elsevier Science Ltd. All rights reserved.