No . 24 - 2011 A Framework to Analyze the Impact of Exchange Rate Uncertainty on Output Decisions

Southern Cone economies exhibit a high record of exchange rate volatility. In this context, firms tend to contract dollar debt, irrespective of their trade orientation, and without available hedging instruments. This exposes them to bankruptcy risk, in the event of large exchange rate movements. This paper provides a framework to analyze the output effect of exchange rate uncertainty in that context, by focusing on the channel uncertainty-output that operates through the financial strategy of the firm. We find that increases in exchange rate uncertainty increase the probability of bankruptcy, thus increasing expected marginal bankruptcy costs, and reducing optimal output of a risk-neutral firm. Furthermore, we find that firms with higher than average liquidity balances will face lower marginal bankruptcy costs, thus producing more than the average firm. The model displays persistence, as any shock to current profits affects future liquidity balances, and so, future output. This framework can easily be extended to explain the response of other firms’ decisions to exchange rate uncertainty, such as investment. JEL Classification: F31, G33, D81