Are Free-Floating Exchange Rate Regimes Advantageous or Disadvantageous for International Trade Growth?

n light of the termination of the US dollar convertibility to gold (end of the Breton Woods exchange rate system, 1971-73), there has been reported a considerable rise in the short-term volatility of the relative price between countries—a dramatic mean-reverting, fluctuating behaviour.

Detractors of the floating exchange rate regime—a regime in which the exchange rate fluctuates in response to foreign-exchange market mechanisms and it is not pegged to any measure of value—argue that its associated volatility is an important drawback for the international monetary system, which increases uncertainty about relative prices. They also state that it leads to restrict international investments and flows of goods and services, which brings negative real-effects to the economy. In parallel with detractors of the floating regimes, the Bretton Woods Commission (1994) urges political organisations to internationally coordinate policies to fight against exchange rate volatility by adopting stabilising measures that may help to avoid potential costs to the economy.

Furthermore, the implicit exchange rate volatility of floating regimes can be observed through a visual inspection of the graphs in (Fig. 1.1) for Japan, Canada and the UK. The floating exchange rate period (since 1971) seems to be systematically associated with a high volatility, in contrast to that of the fixed regime (before 1971). Interestingly, this increased volatility has been matched with a slowdown in international trade flows since 1973. For instance, the balance of trade of the US current account reached to around three hundred billion of US dollars in 1999, its highest mark in the post-war period so far (IMF, 1999). Because of this reason, research efforts over decades have centred on investigating this relationship through several approaches: from the lens of multilateral trade relationships to a more accurate perspective under bilateral approaches.

FIG. 1.1

Exchange Rate Volatility of Japan, Canada and the UK


Source (Muñoz-Salido, 2016)

Notes to the table. Graph shows a PPI-based (2010=1) Real Exchange Rate (RER henceforth) for Japan (first graph), Canada (second graph) and the UK (third graph). Period covered is from 1960/1 to 2015/2, 661 monthly observations for each variable after log-transformations. Red spheres indicate fixed exchange rate periods.

After decades of research, ambiguous contributions have risen the interest of researchers in disentangling the true mechanics of the effect of the exchange rate volatility upon trade growth. Traditionally, the basic methodology for studying this effect has been to run panel data regressions through multilateral approaches. After the first divergences in the empirical literature, the methodologies have been modified and alternative models have been proposed in search of identifying the true underlying relationship between these two variables.

The empirical heritage points to the different exchange rate regimes and trade relationships between countries for explaining the divergence of directions of the aforesaid effect—particular features from different type of trade relationships may impede the true dynamics of this effect to robustly hold. Additionally, research efforts in disentangling such divergence were centred on studying either aggregate of disaggregate data, which did not substantially solve such ambiguity.

In parallel with the empirical literature, there is not consensus among theoretical predictions explaining this effect (i.e. Hooper and Kohlhagen’s, 1976; Newbery and Stiglitz, 1981; Caballero and Corbo’s, 1989). Indeed, this theoretical divergence does not arise from assumptions on the risk aversion of traders but from restrictions and assumptions imposed to the utility function of the theoretical models, which makes even more difficult to identify and correct the causes for this divergence.

By considering all of the aforementioned reflections, are we scientifically able to argue in favour or against free-floating exchange rate regimes for boosting or hindering international trade growth? Indeed, it seems as the empirical spectrum had sown the seeds of the ambiguity and the disrepute within the economic science—then, what else could be done? Is it that theoretical predictions for the macro-level are not as clear-cut as they are for the micro-level? Is it that the lack of empirical accuracy in the macro-level unhinges the theoretical discourse? Or does one has to think that economic science must succumb to Chaos Theory’s negative forces?

Enrique Muñoz-Salido

MSc Candidate in Economics and Finance, University of Brighton. Master's Specialisation Student in Mixed Methods Research, OUDCE, University of Oxford. University of Brighton Santander Scholar. Co-Founder and Secretary of the Brighton University Economics Society.


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