Exchange rate variability and EU trade

The present study focuses on international trade. The aim is to construct a small econometric model allowing the evaluation of the impact of variability on European trade.The report is organised as follows. Section I offers a conceptual analysis of the impact of exchange rate variability on trade. Section II presents previous empirical findings for Europe. The theoretical model relating variability to trade is constructed and analysed in Section III, while Section IV presents the empirical analysis and discusses the major findings. Section V sets out the conclusions. II/051/98 Exchange rate variability is a central theme in the debate on the performance of exchange rate regimes. The consequences of this variability for economic activities have always been a major concern of policy makers. After World War II, the Bretton Woods agreements created the International Monetary Fund and set up a world-wide system of fixed exchange rates. One objective of this system was to foster international exchanges of goods and services.In 1973, the Bretton Woods system was abandoned and many countries allowed their exchange rates to float. The consequence was an increase in exchange rate variability. Hence, the debate on the optimal management of exchange rates attracted renewed attention. It was enhanced by the possibility of a causal link between this increased variability and the observed decline in the growth rate of trade. Advocates of a regime of fixed rates emphasised its merits in terms of co-ordination, discipline and credibility of economic policies, as well as its role in stimulating international trade. The supporters of flexibility put forward its advantages in terms of increased autonomy in pursuing domestic policy objectives.In Europe, policy makers seemed to have been much more convinced by the merits of a regime of fixed rates. In 1972, they created the Snake, a system of fixed exchange rates among member countries. The Snake experienced a number of realignments and the entry and exit of various member countries, which substantially weakened its credibility. A new system of fixed rates was therefore set up in 1979 : the Exchange Rate Mechanism of the European Monetary System (the ERM of the EMS). Despite several realignments during the early eighties, the ERM has succeeded in stabilising exchange rates between member countries. After 1983, realignments become smaller and rarer, and between 1987 and 1992 there was almost no realignment. The stable environment (with respect to exchange rates) during the period 1987-1992 was favourable to the concept of creating Economic and Monetary Union (EMU) in Europe. Some economists argued that the move to EMU should pose no problems because within the ERM, realignments were no longer needed.To illustrate the European experience with exchange rate management, Figure 1 presents the variability of the nominal effective exchange rates (NEER) of four currencies (those of Belgium, Germany, France and Italy) between 1970 and 1995. The variability is computed as the yearly standard deviation of monthly percentage changes in nominal effective exchange rates. Comparing the pre-ERM period to the ERM period, it appears that member countries experienced lower variability in the ERM period. Even during the ERM crisis in the early 1990s, variability is lower than during the pre-ERM period for member countries. The most stable period is clearly 1987-1991. Figure 1 shows that during the ERM period, a non-member country (i.e. the UK) experienced a significantly higher level of variability than the ERM countries . Hence, the ERM may clearly be credited for having reduced exchange variability among participating countries.An abundant empirical literature has analysed the recent European experience of fixed exchange rates. The conclusions of such analyses are of prime importance when examining the potential impact of EMU in Europe. The analyses investigate various aspects of the ERM experience : transmission of shocks, nominal and real convergence, policy co-ordination, international trade, etc.The present study focuses on international trade. The aim is to construct a small econometric model allowing the evaluation of the impact of variability on European trade.The report is organised as follows. Section I offers a conceptual analysis of the impact of exchange rate variability on trade. Section II presents previous empirical findings for Europe. The theoretical model relating variability to trade is constructed and analysed in Section III, while Section IV presents the empirical analysis and discusses the major findings. Section V sets out the conclusions.