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A Framework to Analyze the Impact of Exchange Rate: Uncertainty on Output Decisions

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  • Gonzalo Varela

    (Department of Economics, University of Sussex)

Abstract

Southern Cone economies exhibit a high record of exchange rate volatility. In this context, rms 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 e ect of exchange rate uncertainty in that context, by focusing on the channel uncertainty-output that operates through the nancial strategy of the rm. We nd 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 rm. Furthermore, we nd that rms with higher than average liquidity balances will face lower marginal bankruptcy costs, thus producing more than the average rm. The model displays persistence, as any shock to current pro ts a ects future liquidity balances, and so, future output. This framework can easily be extended to explain the response of other rms' decisions to exchange rate uncertainty, such as investment.

Suggested Citation

  • Gonzalo Varela, 2011. "A Framework to Analyze the Impact of Exchange Rate: Uncertainty on Output Decisions," Working Paper Series 2411, Department of Economics, University of Sussex Business School.
    • Handle: RePEc:sus:susewp:2411
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    File URL: http://www.sussex.ac.uk/economics/documents/wps24-2011-varela-2.pdf
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    References listed on IDEAS

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    Cited by:

    1. Milan Nedeljkovic & Gonzalo Varela & Michele Savini Zangrandi, 2015. "Indonesia Current Account Assessment," World Bank Publications - Reports 22340, The World Bank Group.
    2. Brun,Martin & Gambetta,Juan Pedro & Varela,Gonzalo J., 2020. "Slow Rockets and Fast Feathers or the Link between Exchange Rates and Exports : A Case Study for Pakistan," Policy Research Working Paper Series 9353, The World Bank.
    3. Gonzalo Varela, 2011. "Real Exchange Rate Uncertainty and Output: A Sectoral Analysis," Working Paper Series 2011, Department of Economics, University of Sussex Business School.
    4. Brun, Martin & Gambetta, Juan Pedro & Varela, Gonzalo J., 2022. "Why do exports react less to real exchange rate depreciations than to appreciations? Evidence from Pakistan," Journal of Asian Economics, Elsevier, vol. 81(C).

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    More about this item

    Keywords

    Exchange rates; Bankruptcy Costs; Production Under Uncertainty;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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