Question

How changes in r impact exchange rate and how that impacts net exports?

Answer 1

A disconnect of exchange rates from trade would complicate policymaking. It would weaken a key channel for the transmission of monetary policy and make it harder to reduce trade imbalances via the adjustment of exchange rates.

Exchange rate movements have been unusually large and have sparked some controversy as to their likely effect on exports and imports. Some suggest that exchange rates matter far less than they used to, and may have disconnected from trade entirely. Claims like these are not at all new—they have been around at least since the economist Fritz Machlup coined the phrase ‘elasticity pessimism’ back in 1950.

Concerns that exchange rates may have disconnected from trade have been assuaged in the past. In the 1980s, the US dollar depreciated and the yen appreciated sharply after the 1985 Plaza Accord, but trade volumes were initially slow to adjust. Some commentators then suggested a disconnect between exchange rates and trade. By the early 1990s, however, US and Japanese trade balances had adjusted, largely in line with the predictions of conventional models (Krugman 1991). The question is whether this time will be different, or whether the relationship between exchange rates and trade remains strong.

We use data for more than 50 advanced and emerging market and developing economies over the past three decades. The growing importance of emerging markets in world trade justifies this broad country coverage, which goes beyond the group of countries typically examined in related studies.

Our analysis of historically large exchange rate movements, which include, for example, economies affected by the 1992 European Exchange Rate Mechanism crisis, or the devaluation of the Chinese yuan in 1994, further supports the notion that exchange rate depreciations raise exports. It also suggests that, among economies experiencing currency depreciation, the rise in exports is greatest for those with slack in the domestic economy and with financial systems operating normally.