Journal of Econornics and Finance 9 Volume 22 9 Numbers 2-3 9 Summer~Fall 1998 9 Pages 43-56

The Long-Run and Short-Run

Effects of Exchange-Rate Volatility
on Exports: The Case of
Australia and New Zealand
A.C. Arize and J. Malindretos

ABSTRACT

In this paper we obtain and interpret estimates of the short- and long-
run influence of exchange-rate volatility (or risk) on the volume of trade
of two Pacific-Basin Countries, Australia and New Zealand, in the
generalized floating exchange-rate period. For each country, a unique,
theoretically consistent long-run function is estimated, as well as a
short-run dynamic demand function that is formally superior to a
number of previous estimates.

I. Introduction

One of the most significant features of exchange rate movements in the post-Bretton Woods era has been
the volatility of both real and nominal exchange rates for developed and developing countries. A central
question has been whether the high volatility of exchange rates has hampered the growth in the volume of
international trade. Although much research has been done in recent years concerning the effects of
exchange-rate volatility on the volume of international trade, no consensus has been reached among those
studying both the theoretical and empirical aspects of this issue.
It has been argued that the higher volatility of exchange rates will hamper trade flows by creating
uncertainty about the profits to be made from international trade transactions. This is because most trade
contracts are not for immediate delivery of goods; and, since they are denominated in terms of currency of
either the exporter or the importer, unpredictable changes in exchange rates affect realized profits and,
hence, the volume of trade. Sercu (1992:579) notes that "the argument views traders as bearing
undiversified exchange risk; if hedging is impossible or costly and traders are risk-averse, risk-adjusted
expected profits from trade should fall when exchange risk increases." A number of empirical studies have
provided evidence in support of the hypothesis that exchange-rate volatility depresses trade (Arize, 1995;
Chowdhury, 1993; Pozo, 1992; Per/~e and Steinherr, 1989; De Grauwe, 1988; Thursby and Thursby, 1987;
Kenen and Rodrick, 1986; Akhtar and Hilton, 1984; and Cushman, 1983).
On the other hand, recent theoretical developments suggest that there are situations in which the volatility
of exchange rate could be expected to have negative or positive effects on trade volume. De Grauwe (1988)

The author would like to thank Ed Manton, Keith McFarland and Wendell Edwards for helpfu] comments
on an earlier draft. Special thanks to Kathleen Smith for excellent research assistance. This research is
funded by a GSRF-TAMU-C grant.
A.C. Atize, College of Business and Technology, Texas A&M University - Commerce, Commerce, 77( 75429
J. Malindretos, , Department of Economics and Finance, College of Business Administration, St. John's University, NY 11439
 44 JOURNAL OF ECONOMICSAND FINANCE 9 Volume22 9 Numbers2-3 9 Summer~Fall1998

has stressed that the dominance of income effects over substitution effects can lead to a positive relationship
between trade and exchange-rate volatility. He suggests that the effects of exchange-rate uncertainty on
exports depend on the degree of risk aversion. A very risk-averse exporter who worries about the decline
in revenue may export more when risks are higher. On the other hand, a less risk-averse individual may not
be concerned with the worst possible outcome and, considering the return on exports less attractive, may
decide to export less when risks are higher.
Baldwin and Krugman (1989) and Dixit (1989) have shown that, in the hysteretic models of trade,
exchange-rate volatility can also influence trade. When significant sunk costs are involved in international
transactions, exchange-rate uncertainty can affect trade behavior, even when agents are risk-neutral. In such
a case, uncertainty can alter the option value of not participating in trade activity. As with 'risk aversion'
models, it is not always clear how trade will be affected. For example, Froot and Klemperer (1989: 643)
show that exchange-rate uncertainty can affect the price and quantity of trade, either positively or negatively,
when market share matters under an oligopolistic market structure, regardless of tastes for risk. Brissimis
and Leventakis (1989) is an example of a study that found a significant positive relationship between
exchange-rate volatility and trade. On the other hand, several empirical studies (Gotur, 1985; and Medhora,
1990) fail to find conclusive evidence that exchange-rate volatility has had a significant effect on trade
flows. All in all, the empirical evidence has at best been mixed.
Most previous studies have focused their attention on G-7 countries (especially the United States),
therefore the contribution of this study to the literature on the influence of exchange-rate volatility on the
volume of exports is the extension of the analysis to two Pacific-Basin countries: Australia and New
Zealand. Very little attention, if any, has been devoted to the Pacific-Basin countries in this area. The
approach taken here is quite different from the level or first-difference specifications and stock adjustment
mechanism employed in most previous studies. Such specifications have been the subject of much recent
work, the bulk of which suggests that they fail on theoretical and econometric grounds) In this study, new
econometric techniques that integrate the level and first-difference specifications are employed. To examine
whether a long-run equilibrium relationship between real exports and exchange-rate volatility exists, a
cointegration technique is employed. The short-run dynamics by which real exports converge on their
equilibrium long-term values are examined by employing an error-correction procedure.
Second, as far as is known, the specifications used in most previous studies have implicitly assumed data
stationarity; however, it is highly unlikely that the utilized data have this desirable characteristic. As shown
by Nelson and Piosser (1982), several macroeconomic variables are clearly nonstationary, and this should
have important implications for the formulation of time series models. Therefore, this paper focuses upon
the correct representation of the data to avoid misleading inferences (see Phillips, 1986). In the first step,
we establish initially the properties of the individual time series prior to testing for cointegration. Series that
are integrated of a different order cannot be cointegrated.2 In the second step, we employ the maximum
likelihood framework for estimating cointegrating vectors between integrated series suggested by Johansen
(1988). In the third step, we introduce the estimated error-correction term from the Johansen procedure into
our error-correction model.
Third, this study contains a careful examination of the residuals. In particular, it tests for higher-order
autocorrelation, functional form misspecification, heteroskedasticity, and non-normal residuals. It is
important to mention that previous studies fail to extensively examine the validity of their econometric
model. For example, the only diagnostic test provided by the majority of these studies is the Durbin and
Watson statistic for a first-order serial correlation, so it is unclear as to whether the residuals of these models
satisfy the assumptions of classical linear regression models.
Fourth, this study uses quarterly data, instead of annual data as did some previous studies. It focuses on
the recent flexible exchange-rate period from the second quarter of 1973 through the fourth quarter of 1992
and employs a longer sample period than any of the previous studies in this" area. Note that some of the
previous studies estimate their export demand equation with pooled data of both fixed and flexible
exchange rate periods without justification for the equations being symmetrical during the periods. For
example, Cushman (1983) uses data for the period 1965 through 1975, whereas Perle and Steinherr (1989)
cover the annual period, 1960 through 1985. Work by De Grauwe (1988:70), Himarios (1989:1046),
McNown and Wallace (1992:108) and Arize and Walker (1992:48) suggests that the use of such
nonhomogeneous samples may unduly bias the results.