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posted on 04 October 2015

Exchange Rates And Trade Flows: Disconnected?

from the International Monetary Fund

Recent exchange rate movements have been unusually large, triggering a debate regarding their likely effects on trade. Historical experience in advanced and emerging market and developing economies suggests that exchange rate movements typically have sizable effects on export and import volumes. A 10 percent real effective depreciation in an economy's currency is associated with a rise in real net exports of, on average, 1.5 percent of GDP, with substantial cross-country variation around this average.

Although these effects fully materialize over a number of years, much of the adjustment occurs in the first year. The boost to exports associated with currency depreciation is found to be largest in countries with initial economic slack and with domestic financial systems that are operating normally. Some evidence suggests that the rise of global value chains has weakened the relationship between exchange rates and trade in intermediate products used as inputs into other economies' exports. However, the bulk of global trade still consists of conventional trade, and there is little evidence of a general trend toward disconnect between exchange rates and total exports and imports.

Recent exchange rate movements have been unusually large. Th e U.S. dollar has appreciated by more than 10 percent in real eff ective terms since mid-2014. The euro has depreciated by more than 10 percent since early 2014 and the yen by more than 30 percent since mid-2012 (Figure 3.1). Such movements, although not unprecedented, are well outside these currencies' normal fl uctuation ranges. Even for emerging market and developing economies, whose currencies typically fluctuate more than those of advanced economies, the recent movements have been unusually large.

There is little consensus, however, on the likely effects of these large exchange rate movements on trade - - exports and imports - - and, therefore, on economic activity. Some have predicted strong effects, based on conventional economic models (Krugman 2015, for example). Others have pointed to the limited changes in trade balances in some economies following recent exchange rate movements - in Japan, in particular - implying an apparent disconnect between exchange rates and trade. It has also been suggested that the increasing participation of firms in global value chains has reduced the relevance of exchange rate movements for trade flows, as in recent studies conducted at the Organisation for Economic Co-operation and Development (Ollivaud, Rusticelli, and Schwellnus 2015) and the World Bank (Ahmed, Appendino, and Ruta 2015).

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