Exchange rate volatility and Canadian manufactured exports

Abstract

This study investigates the effects of exchange rate volatility on Canadian manufactured exports for the period 1972Q3 to 1993Q4. Exchange rate volatility can be defined as the variance of the exchange rate, and there is no theoretical or empirical consensus as to its effect on trade. Unlike previous studies' that only examine the effects of short run volatility, this study distinguishes between short and long run volatility effects. Short run volatility is modelled using GARCH and Forward-Difference models, and long run volatility is measured as the effect of persistent deviations from the PPP exchange rate. Where as past studies have also assumed the export function to be a long run equilibrium demand equation2 , this study calculates both an export demand and supply equation. Using an export supply equation, both short and long term volatility effects were determined to be significant. Alternatively, testing with export demand equation, only short run volatility effects were found to be significant. The results of this study indicate that the magnitude and significance of the exchange rate volatility effect is dependent on the choice of export specification, and therefore a demand equation cannot be used without justification. The invoicing currency of Canadian exporters is used to determine Canadian bare the exchange rate risk, and therefore the effects of exchange rate volatility should be tested in an export supply equation. The validity of this approach is supported by the fact that more volatility effects were determined to be significant in the export specification selected on the basis of the invoicing currency.