Identifying the e¤ect of Exchange Rate Volatility on the Composition and Volume of Trade

We use a model of international trade to show that (i) trade a¤ects exchange rate volatility and (ii) exchange rate volatility impacts trade in goods di¤erently according to their degree of di¤erentiation. In particular, commodity goods are less a¤ected by exchange rate volatility than more highly di¤erentiated products. These insights allow us to structurally address one of the main shortcomings of the existing empirical literature on the e¤ects of exchange rate volatility on trade – the failure to correct for reverse causality. Using disaggregate trade data for a large number of countries for the period 1970-1997 we ...nd strong results supporting predictions (i) and (ii). We then use these results to uncover the e¤ect of exchange rate volatility on trade. We ...nd that once we address the reverse-causality problem, the large e¤ects of volatility on trade found in previous literature are greatly reduced.