EXCHANGE RATE VOLATILITY AND TRADE/PRODUCTIVITY IN AUSTRALIA

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1 The Universiy of Queensland Faculy of Business, Economics and Law School of Economics EXCHANGE RATE VOLATILITY AND TRADE/PRODUCTIVITY IN AUSTRALIA Approximae Word Lengh: 25,000 An Honours Thesis submied o he School of Economics, The Universiy of Queensland, in parial fulfilmen of he requiremens for he degree of BEcon (Honours). By Shuwei Jasmine Zheng 2 November 2005

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3 DECLARATION I declare ha he work presened in his Honours hesis is, o he bes of my knowledge and belief, original and my own work, excep as acknowledged in he ex, and ha maerial has no been submied, eiher in whole or in par, for a degree a his or any oher universiy. Shuwei Jasmine Zheng 2 November 2005 i

4 ACKNOWLEDGEMENTS Firsly, I would like o hank my supervisor Dr Philip Bodman for his assisance in he preparaion of his hesis and grea advice given hrough he year. More imporanly, I am hankful for his opimism and encouragemens ha have in many ways kep his year going. Secondly, I would also like o hank Dr Renuka Mahadevan for personal advices given hrough he year which I really do appreciae i a lo. Thirdly, hank you o my parens for heir invesmen in my educaion which has no been easy a imes. A big hank you also goes ou o all my friends who undersood and encouraged me hrough he roller-coasers of he year. And, o he Honours Class of 2005: Thank you for jus being here. Semeser 1 was grea fun albei he counless assignmens. Finally, THANK YOU o everyone who believes in me. ii

5 ABSTRACT In Ausralia, exchange rae volailiy has significanly increased afer he floaing of he exchange rae in On an inernaional basis, here have been concerns abou he possible derimenal effecs exchange rae volailiy could have on rade volumes and produciviy levels. Since produciviy growh and rade have been regarded as crucial facors in he promoion of susainable economic growh and improving he maerial living sandards for Ausralians, furher research ino he relaionship beween exchange rae volailiy and rade/produciviy will prove o be useful o policy makers. The objecive of his sudy is wofold. Firsly, in ligh of he Ausralia-Unied Saes (US) produciviy gap, his hesis will invesigae wheher here is reverse causaliy flowing from he real exchange rae movemens/volailiy o labour produciviy in Ausralia. The imporance of significan exchange rae depreciaion/volailiy having a negaive impac on produciviy has been highlighed by Harris (2002) for he case of Canada. Secondly, he impac of exchange rae volailiy on Ausralian expor volumes o US and Japan will be analysed. Alhough exensive heoreical and empirical research on his relaionship has been conduced, his issue has remained highly ambiguous. To dae, no empirical sudy has aken ino consideraion he hreshold effecs of exchange rae volailiy on expor volumes. Therefore, his hesis examines he relaionship beween exchange rae volailiy and rade/produciviy via linear and non linear hreshold esimaions of he rade and produciviy models. The non linear hreshold models esimaion in his hesis is based on Hansen (2000) s mehodology. To ensure ha sound economic inerpreaions of he models can be made, coinegraion ess will be conduced and Vecor Error Correcion Models (VECMs) will be esimaed. The economeric resuls obained from his hesis indicae ha long run equilibrium relaionships beween exchange rae volailiy and rade/produciviy exis. However, Granger Causaliy ess employed could no find evidences supporing he reverse causaliy link for he case of produciviy. Finally, significan hreshold effecs of exchange rae volailiy on rade/produciviy have been esed for, suggesing ha sandard rade/produciviy models involving exchange rae volailiy have undersaed heir rue underlying relaionships. iii

6 Keywords: Trade volumes, produciviy, exchange rae volailiy, reverse causaliy, non lineariy, hreshold effecs, Ausralia, asymmery iv

7 CONTENTS ABSTRACT... iii CHAPTER 1: INTRODUCTION Objecive Background Trade Produciviy Conribuions Brief Summary of Findings Srucure of hesis...10 CHAPTER 2: LITERATURE REVIEW TRADE Inroducion Basic Trade Uncerainy Models Exensions o he Basic Trade Uncerainy Models Hedging Opions Degree of Risk-Aversion and Profi Opporuniies Oher facors and frameworks Trade hyseresis Empirical Evidence Concluding Remarks...23 CHAPTER 3: LITERATURE REVIEW PRODUCTIVITY An Overview The Exchange Rae and Endogenous Produciviy Reverse Causaliy? Relaive Facor Cos Hypohesis Innovaion Gap Hypohesis Exchange Rae Shelering Hypohesis Asymmeric Produciviy Dynamics Model Oher Deerminans of Produciviy Empirical Evidence...36 v

8 3.6 Concluding Remarks...39 CHAPTER 4: DATA DESCRIPTION Inroducion Definiions, measuremen and sources of Variables Variables Included in he Trade Models Variables Included in he Produciviy Models...46 CHAPTER 5: MODEL SPECIFICATION AND METHODOLOGY Inroducion Model Specificaion The Basic Trade Model The Trade Threshold Model Esimaion of he Unknown Threshold Poin The Basic Produciviy Model The Produciviy Threshold Model Daa Pre-esing Uni Roo Tess Real Exchange Rae Volailiy Measures Mulivariae Coinegraion Analysis Johansen Coinegraion Tes Specificaion of number of lags Conducing he Johansen Coinegraion Tes VECM Esimaion Granger Causaliy Tess Innovaion Accouning Impulse Response funcions Variance Decomposiions...72 CHAPTER 6: EMPIRICAL ANALYSIS TRADE Inroducion Measuremen of Real Exchange Rae Volailiy Tess for Saionariy of Daa Economic Inerpreaion of he Basic Trade Models...84 vi

9 6.5 Esimaion of he Unknown Threshold Poin ( τ ) Economic Inerpreaion of he Trade Threshold Models Tess for Coinegraion VECM Esimaion Granger Non Causaliy Tess Innovaion Accouning Concluding Remarks CHAPTER 7: EMPIRICAL ANALYSIS PRODUCTIVITY Inroducion Measuremen of USD/AUD Real Exchange Rae volailiy Tess for Saionariy of Daa Economic Inerpreaion of he Basic Labour Produciviy Model Esimaion of he Unknown Threshold Poin ( ) τ Economic Inerpreaion of he Produciviy Threshold Model Tess for Coinegraion VECM Esimaion Granger Non Causaliy Tess Innovaion Accouning Concluding Remarks CHAPTER 8: CONCLUSIONS AND DIRECTIONS FOR FUITURE RESEARCH Summary Policy Implicaions Limiaions and Recommendaions for Fuure Research CHAPTER 9: DATA APPENDICES vii

10 LIST OF ABBREVIATIONS AND ACRONYMNS ABBR. ADF ARCH ARMA AUD B-S CPI FOP GARCH GARCH-M GDP ICT ITT IFS IRF KPSS OECD PP R & D US USD VECM YEN DESCRIPTION Augmened Dickey Fuller Auoregressive Condiional Heeroskedasiciy Auocorrelaion Moving Average Auocorrelaion Ausralian Dollar Balassa Samuelson Consumer Price Index Facors of Producion Generalised Auoregressive Condiional Heeroskedasiciy GARCH-in-Mean Model Gross Domesic Produc Informaion and Communicaions Technology Informaion Technology and Telecommunicaions Inernaional Financial Saisics Impulse response Funcion Kwiakowski, Phillips, Schmid, and Shin Organisaion for Economic Co-operaion and Developmen Phillips-Perron Research and Developmen Unied Saes Unied Saes Dollar Vecor Error Correcion Model Japanese Dollar viii

11 LIST OF FIGURES Figure 1.1: USD/AUD Real Exchange Rae Volailiy and Aus US Trade Volumes...4 Figure 1.2: YEN/AUD Real Exchange Rae Volailiy and Aus Japan Trade...5 Volumes...5 Figure 1.3: Per Capia GDP Growh OECD, US, Ausralia...6 Figure 1.4: Relaive Labour Produciviy: Ausralia vs. US...7 Figure 3.1: The Relaionship beween he Real Exchange Rae, Produciviy and Sandard of Living...26 Figure 3.2: Asymmeric Adverse Demand Shock...34 Figure 6.1: Time plo for LRUS...74 Figure 6.2: Correlogram for LRUS...75 Figure 6.3: Time plo for LRYEN...75 Figure 6.4: Correlogram for LRYEN...76 Figure 6.5 Impulse Response Funcions - Basic US Trade VECM...99 Figure 6.6: Impulse Response Funcions Basic Japan Trade VECM Figure 7.1: Time plo of LR Figure 7.2: Correlogram for LR Figure 7.3: Impulse Response Funcions Basic Produciviy VECM ix

12 LIST OF TABLES Table 2.1: Daa Sources for US/Japan Trade Models...45 Table 2.2: Daa Sources for Produciviy Models...48 Table 5.1: Deerminisic componens considered in he VECM...69 Table 6.1: Analysis of mean funcions for USD/AUD Real Exchange rae (LRUS)...77 Table 6.2: Analysis of mean funcions for YEN/AUD Real Exchange rae (LRYEN)...77 Table 6.3: USD/AUD Volailiy Analysis...79 Table 6.4: YEN/AUD Volailiy Analysis...81 Table 6.5: Summary Resuls of ADF, PP and KPSS ess (US)...82 Table 6.6: Summary Resuls of ADF, PP and KPSS ess (Japan)...83 Table 6.7: US and Japan Basic Trade Models...84 Table 6.8: Esimaed Threshold Values...86 Table 6.9: Threshold Trade Models...88 Table 6.10: Coinegraion Tes for US Basic Trade Model...92 Table 6.11: Coinegraion Tes for Japan Basic Trade Model...93 Table 6.12: Error Correcion Terms from Basic US Trade VECM...95 Table 6.13: Error Correcion Terms from Basic Japan Trade VECM...95 Table 6.14: Granger Causaliy Resuls based on Basic US Trade VECM...97 Table 6.15: Granger Causaliy Resuls based on Basic Japan Trade VECM...97 Table 6.16: IRFs for Basic US Trade VECM...98 Table 6.18: Variance Decomposiion for US Table 7.1: Analysis of mean funcions for USD/AUD Real Exchange rae (LR) Table 7.2: USD/AUD Volailiy Analysis Table 7.3: Resuls of ADF, PP and KPSS ess Table 7.4: Resuls for he Basic Labour Produciviy Model Table 7.5: Resuls for he Esimaed Threshold Value Table 7.6: Resuls for he Labour Produciviy Threshold Model Table 7.7: Johansen Coinegraion Tes for he Basic Produciviy Model Table 7.8: Error Correcion Terms from Basic Produciviy VECM x

13 Table 7.9: Granger Causaliy Resuls based on Basic Produciviy VECM xi

14 CHAPTER 1: INTRODUCTION Our sandard of living he qualiy of our communiies, he prosperiy of our families, and he securiy of our jobs depends more han ever on our abiliy o compee in he global markeplace - Mark Vaile, Ausralian Miniser for Trade (April 2002) Produciviy isn' everyhing, bu in he long run i is almos everyhing. A counry's abiliy o improve is sandard of living over ime depends almos enirely on is abiliy o raise is oupu per worker. - Paul Krugman (1992, p. 9) Over long periods of ime, small differences in raes of produciviy growh compound, like ineres in a bank accoun, and can make an enormous difference o a sociey's prosperiy. Nohing conribues more o reducion of povery, o increases in leisure, and o he counry's abiliy o finance educaion, public healh, environmen and he ars. - Alan Blinder and William Baumol (1993, p. 778) 1.1 Objecive I is indeed rue ha produciviy and rade performances are of serious concern and opical relevance. For a small, ye open economy like Ausralia, produciviy growh and rade performance are known o be key moivaing facors behind he promoion of susainable economic growh and he improvemen of maerial living sandards. Since he floaing of he Ausralian exchange rae in December 1983, here has been an observed increase in exchange rae volailiy. This has also been he general phenomenon observed from an inernaional perspecive. This increase in exchange rae volailiy led Harris (2001) o argue for he case of Canada ha exchange rae depreciaion as well as he increase in volailiy could have a significan negaive impac on produciviy here. Since 1

15 he exchange rae floa in 1983, here have also been concerns abou he possible derimenal effecs exchange rae volailiy could have on rade volumes. While here have been several previous empirical sudies on his issue, no consensus have been reached. One noable feaure of hese previous sudies has been he implici assumpion of symmery in he effec of exchange rae volailiy on rade volumes. These observaions led o he following quesions his hesis seeks o address in he conex of Ausralia: 1. Has susained exchange rae depreciaions, observed paricularly in he 1990s, as well as he increase in exchange rae volailiy (pos-floa) led o a negaive impac on labour produciviy? 2. Has he increase in exchange rae volailiy since he floa negaively impaced expor volumes in Ausralia? 3. Do hreshold effecs of exchange rae volailiy on labour produciviy and expor volumes exis? If so, can his provide a beer undersanding of he rue underlying relaionship beween exchange rae volailiy and produciviy/rade? The res of his chaper will be organised as follows. Secion 1.2 will review he background of produciviy and rade performances in he conex of Ausralia providing a moivaion for his hesis. The conribuions of his hesis o he exising lieraure will be discussed in Secion 1.3. In Secion 1.4, he srucure of he hesis will be saed. 1.2 Background There are valid reasons as o why Ausralians should be concerned abou he produciviy and rade performances of Ausralia. The following wo sub-secions will succincly explain he imporance of produciviy and rade performances o he improvemen of sandard of living for Ausralians. 2

16 1.2.1 Trade One imporan facor conribuing o an improvemen of he maerial sandard of living for Ausralians is rading relaions beween Ausralia and he res of he world. More specifically, his hesis is concerned wih Ausralian expor volumes. According o DFAT (2005b), 1 in 5 Ausralian jobs relies on expors. As such, a 10 per cen increase in expors could creae 70,000 new Ausralian jobs. Wih he move owards floaing exchange raes, here have been concerns abou he possible derimenal effecs exchange rae volailiy could have on rade volumes boh on an inernaional basis and in he conex of Ausralia. However, based on he exising heoreical models and previous empirical sudies conduced in his area, here has been no consensus reached on he impac of exchange rae volailiy on rade volumes. Depending on he assumpions made, he impac could be posiive, negaive or even zero. According o DFAT (2005c), he wo major expor markes for Ausralia are he Unied Saes (US) and Japan. Hence, i may be useful o look a he movemen of rade volumes and exchange rae volailiy for each marke over ime. Figures 1.1 and 1.2 show he relevan movemens in rade volumes and real exchange rae volailiy for he US and Japan respecively. For Figures 1.1 and 1.2, rade volumes are calculaed by summing he real expor volumes o US/ Japan and real impor volumes from US/Japan. The real exchange rae is expressed in volume noaion forma. This implies ha an appreciaion of he exchange rae is equivalen o an increase in he exchange rae. The real exchange rae volailiies are modelled using he Generalised Auoregressive Condiional Heeroskedasic (GARCH) procedure. 3

17 Figure 1.1: USD/AUD Real Exchange Rae Volailiy and Aus US Trade Volumes Millions Real US/AUD Volailiy Q2 1989Q2 1990Q2 1991Q2 1992Q2 1993Q2 1994Q2 1995Q2 1996Q2 1997Q2 1998Q2 1999Q2 2000Q2 2001Q2 2002Q2 2003Q2 2004Q2 Year Aus-US Trade Volume Real US/AUD Vol Source: Auhor s own calculaion of volailiy measure based on USD/AUD Real exchange rae obained from he RBA Bullein Daabase in dx Daabase; Expor and Impor Volumes obained from ABS Time Series Saisics Plus in dx Daabase As seen in Figure 1.1, in some of he years, here appears o be a negaive associaion beween he USD/AUD real exchange rae volailiy and he volume of rade. This can be observed from 1999:2 o 2000:2. Similarly for he case of Japan, as observed from Figure 1.2 overleaf, from 1995:2 o 1996:2, he exreme increase in YEN/AUD real exchange rae volailiy can be seen as having a negaive associaion wih rade volumes beween Ausralia and Japan. The general increase in rade volumes beween Ausralia and Japan from 1997 reflecs he increasing imporance of Japan as a rading parner o Ausralia in recen years. 4

18 Figure 1.2: YEN/AUD Real Exchange Rae Volailiy and Aus Japan Trade Volumes Millions Real YEN/AUD Volailiy Q2 1989Q2 1990Q2 1991Q2 1992Q2 1993Q2 1994Q2 1995Q2 1996Q2 1997Q2 1998Q2 1999Q2 2000Q2 2001Q2 2002Q2 2003Q2 2004Q2 Year Aus-Japan Trade Volumes Real Yen/AUD Vol Source: Auhor s own calculaion of volailiy measure based on YEN/AUD Real exchange rae obained from he RBA Bullein Daabase in dx Daabase; Expor and Impor Volumes obained from ABS Time Series Saisics Plus in dx Daabase Of course, he negaive associaion observed in boh Figures 1.1 and 1.2 may no reflec a causal relaionship. Hence, furher research needs o be underaken o empirically analyse he relaionship beween exchange rae volailiy and rade volumes for he case of he US and Japan. Moreover, one common assumpion made by earlier sudies in his area has been he symmeric effec of exchange rae volailiy on rade volumes. This is unrealisic as i can be shown ha i is possible for firms o reac differenly o varying degrees of volailiy (exchange rae risk). The explanaion for his is aken on furher in Chaper 3. 5

19 1.2.2 Produciviy Over he pas hree decades, wo-hirds of he improvemen in average real incomes of Ausralians has been aribuable o produciviy growh (Indusry Commission 1997). In paricular, by he end of he 1990s, Ausralian households were geing an addiional $7000 increase in income on average as compared o he 1980s (Produciviy Commission 2004). According o Figure 1.3 below, Ausralia s GDP per capia growh has increased by more han 0.5 per cen faser han he US and he OECD counries in he 1990s and 2000s. Figure 1.3: Per Capia GDP Growh OECD, US, Ausralia Per cen s 1960s 1970s 1980s 1990s 2000s OECD Unied Saes Ausralia Source: Groningen Growh and Developmen Cenre and The Conference Board, Toal Economy Daabase, Augus 2005, available a hp:// accessed 10 Sepember Using Gross Domesic Produc (GDP) per capia as an aggregae indicaion of living sandards, Ausralia s GDP per capia relaive o ha of he US improved from approximaely 76 per cen in 1983 o 79 per cen in However, his is only slighly above he relaive posiion ha Ausralia was in during he 1950s. While Ausralia s GDP per capia has clearly improved, i is sill below he bes in OECD including counries like he US, Swizerland and Luxembourg. 6

20 Clearly much of he increase in GDP per capia has been due o a cach up in Ausralia s relaive produciviy level. In Figure 1.4 below, i can be observed ha Ausralia s produciviy level relaive o US has risen from around 78 per cen o 85 per cen in As Blinder and Baumol (1993) argued, even small bu coninuous improvemens in produciviy add value o he economy. According o he Indusry Commission (1997), mainaining a 2 per cen produciviy growh per year could raise average real incomes of he nex generaion by an addiional 13 per cen and he generaion afer ha by an addiional 30 per cen. Figure 1.4: Relaive Labour Produciviy 1 : Ausralia vs. US Ausralia as per cen of US GDP per hour GDP per person Source: Daa for Ausralia-US Relaive Labour Produciviy obained from Groningen Growh and Developmen Cenre and he Conference Board, Toal Economy Daabase, accessed 10 Ocober 2005, available a hp:// 1 Two commonly used measures of labour produciviy are shown in Figure 1.2. This hesis defines real labour produciviy as real indusry value added oupu divided by oal hours worked in he economy. While he per person measure appears o undersae real labour produciviy, similar rends can be observed in boh measures. 7

21 While Figure 1.4 indicaes ha Ausralia s produciviy growh has hi a record high in he 1990s, he economy appears o remain in a cach-up phase from an inernaional perspecive. Moreover, in recen years following he peak in 1998, Ausralia s produciviy level relaive o US has in fac been declining, o approximaely 80 per cen in As Ausralia is a relaively small open economy, he produciviy levels achieved for he US aggregae economy may no be feasible wih is curren se of resource endowmens. Noneheless, he produciviy gap beween Ausralia and he US and some oher OECD counries remain indicaive of he fac ha Ausralia s poenial o achieve even higher produciviy levels has no been diminished. Wih he recen decline in Ausralia s relaive produciviy levels o he US from approximaely 85 per cen in 1998 o 80 per cen in 2004, he issue of a poenially widening produciviy gap beween Ausralia and US becomes increasingly imporan and warrans furher research. Indeed, in recen years, he Produciviy Commission s key area of research has included he monioring and invesigaing of deerminans of produciviy growh. Much of hese effors have mainly concenraed on microeconomic policy reforms and heir impac on produciviy improvemens in he economy. As a resul, a range of indicaors confirm ha srucural reforms, including naional compeiion policy, have been he principal conribuors o ha surge in produciviy and income (Produciviy Commission 2004). To ensure coninuous fuure improvemens o Ausralians sandard of living, produciviy improvemens are clearly essenial. While hese earlier srucural reforms have been successful, i has o be noed ha his does no guaranees fuure success. Hence, i appears imperaive o examine oher possible deerminans of produciviy levels in Ausralia. As menioned earlier, Harris (2002) has suggesed he possibiliy of exchange rae facors negaively influencing produciviy levels for he case of Canada. The hree main reasons ha have been suggesed for his causal channel and discussed in Chaper 3 includes: he relaive facor cos hypohesis, he innovaion gap hypohesis and he shelering exchange rae mechanism. 8

22 In ligh of he preceding discussions, he research in his hesis seeks o empirically analyse and esablish a more in-deph undersanding on an aggregae basis of he relaionship beween real exchange rae depreciaions/volailiy and labour produciviy levels in Ausralia. In addiion, an empirical invesigaion of he relaionship beween real exchange rae volailiy and Ausralian expor volumes o he US and Japan is also underaken. The empirical analyses will be conduced via a sandard linear approach, as well as he nonlinear modelling approach oulined in Hansen (2000) o uncover possible asymmeries and hreshold effecs. The shor run dynamics of he relaionships analysed will also be invesigaed in his hesis. 1.3 Conribuions In achieving hese objecives, his hesis conribues o he exising lieraure in he following manner: 1. Provides a formal esimaion of he relaionship beween real exchange rae depreciaions/volailiy and real labour produciviy in he conex of Ausralia. 2. Incorporaes he possibiliy of asymmeries and hreshold effecs of exchange rae volailiy on labour produciviy in Ausralia. 3. Esablishes he relaionship beween real exchange rae volailiy and Ausralian expor volumes o he US and Japan and mos imporanly, his hesis will be he firs o empirically esimae he hreshold effec of exchange rae volailiy on expor volumes o he US and Japan. 1.4 Brief Summary of Findings The main findings of his hesis from he empirical analyses conduced can be summarised as follows: 1. No evidence is found o subsaniae he claim ha real exchange rae depreciaions negaively influence labour produciviy levels in Ausralia. In fac, empirical evidence found in his sudy suppored he compeiiveness approach which saes ha exchange 9

23 rae depreciaions will increase inernaional price compeiiveness, hus increasing produciviy and hence oupu growh. 2. However, he inclusion of he hreshold effec of USD/AUD real exchange rae volailiy appears o affec he real labour produciviy levels in Ausralia in a significan negaive manner. 3. The evidence appears o subsaniae he Balassa-Samuelson hypohesis, bu no he reverse causaliy link as suggesed by Harris (2002). 4. The basic rade models show ha he impac of real exchange rae volailiy on Ausralian real expor volumes o he US and Japan are negaive and posiive respecively. However, when he hreshold effec of real exchange rae volailiy is accouned for, here is an unambiguous significan overall negaive impac on real expor volumes o he US and Japan. 1.5 Srucure of hesis The ouline of he hesis is as follows. The nex chaper will review he lieraure surrounding he effec of exchange rae volailiy on rade volumes. Specifically, he reasons behind he empirical ambiguiies observed in previous sudies will be discussed, relaing hem back o rade hyseresis. A review of he previous empirical sudies in his area will also be provided, wih is limiaions highlighed. Chaper 3 provides he lieraure review on he relaionship beween exchange rae depreciaions/volailiy and labour produciviy. In paricular, reasons behind he proposed reverse causaliy link will be looked a. A review of he exising, limied empirical sudies will also be provided. Chaper 4 provides a succinc descripion of he definiions, measuremen and daa sources of he variables used in his sudy. This is followed by a deailed discussion in Chaper 5 of he various empirical mehodologies employed in his sudy, including derivaion of he volailiy measures, uni roo ess, esimaion of he hreshold models and esimaion of vecor error correcion models (VECMs). Chaper 6 and 7 presens he economeric resuls from he analysis on expor volumes and labour produciviy respecively. Finally, Chaper 8 offers some concluding remarks, as well as he implicaions of his sudy for policy 10

24 formulaion, limiaions of he sudy and recommendaions for fuure research. A complee daa appendix is provided in Chaper 9. 11

25 CHAPTER 2: LITERATURE REVIEW TRADE 2.1 Inroducion Afer he breakdown of he Breon Woods sysem, fixed exchange rae sysems in mos counries were replaced by some form of flexible sysem of exchange rae deerminaion. In Ausralia and many oher counries, an observable difference beween he fixed and floaing exchange rae regimes has been he significan increase in exchange rae volailiy ha has accompanied he swich o flexible raes. Whils here have been many argumens in favour of flexible exchange raes, here have also been concerns raised by some commenaors, including he poenial derimenal effecs exchange rae volailiy can have on rade volumes (and produciviy levels). However, oher auhors argue ha exchange rae volailiy has eiher no effec or even possibly a posiive effec on rade volumes. Depending on he assumpions made, differen heoreical models arrive a opposing conclusions. Empirical sudies in he recen lieraure have also been ambiguous. Perhaps, he only consensus reached on his issue has been ha he impac of exchange rae volailiy on rade volumes, if any, is difficul o esimae. This chaper will be organised as follows. In Secion 2.2, he earlier basic rade uncerainy models, which mainly argue for he negaive impac of exchange rae volailiy on rade volumes, are discussed. In Secion 2.3, discussions on he various exensions made o he basic rade uncerainy models are presened. These exensions include considering he degree of risk-aversion, he plausibiliy of hedging and looking a his issue from various oher frameworks. An overview of he exising lieraure on rade hyseresis is presened in Secion 2.4. This is followed by a review of he recen empirical sudies on he relaionship beween exchange rae volailiy and rade volumes oulined in Secion 2.5. Finally, concluding remarks are provided in Secion

26 2.2 Basic Trade Uncerainy Models One of he earlier heoreical sudies ha invesigaed he impac of exchange rae volailiy on rade volumes was Clark (1973). The auhor developed a model ha consiss of a perfecly compeiive exporing firm wih no marke power. The firm produces one homogenous commodiy and uses no impored inpus. I is assumed ha he firm is paid in foreign currency whereby expors revenues are convered a he curren exchange rae. Hedging is limied. In addiion, oupu is consan over he planning horizon. Due o he coss involved in adjusing producion scales, he firm mus make producion decisions before observing any exchange rae movemens. In making producion decisions, uncerainy abou fuure exchange raes, which ranslaes ino uncerainy on revenues from fuure expor receips in domesic currency, mus be accouned for. Consequenly, he exporing firm is unable o aler is oupu in response o volailiy in he real exchange rae, wheher he movemen in he real exchange rae is favourable or unfavourable. In his insance, he uncerainy on he firm s expor revenues is enirely dependen on exchange rae risk. Therefore, higher volailiy in exchange raes resuls in uncerainy abou expeced profis from rading. This in urn causes hese firms o reduce ransacions. Oher early heoreical sudies ha had made similar assumpions and argumens include Hooper and Kohlhagen (1978) and Ehier (1973). An opposing viewpoin was developed in Baron (1976). He produced a model ha shows ha an increase in exchange rae volailiy may no necessarily influence he level of rade. The model relaxes he assumpion of perfec compeiion and focuses on he role of invoicing currency. In his insance, he exporing firm faces price risk if conracs are invoiced in he foreign currency. 2 While he quaniy demanded is known as prices do no change during he conrac period, he revenue sream and profis are uncerain. However, if he foreign currency is depreciaing, he loss o he exporer is parly offse by he higher foreign currency expor price, a poin furher developed in Cushman (1983). In addiion, Clark (1973) also noed ha producion coss could be lowered if he exporing firms were 2 I should be noed ha his is applicable o Ausralia as according o ABS (2005), he US dollar accouned for 69 per cen of expor invoices in 2004, and 72 per cen in March quarer

27 o use impored inpus from a counry whose currency is depreciaing, which would offse he declining expor revenues also. 2.3 Exensions o he Basic Trade Uncerainy Models These earlier rade uncerainy models gave us an idea of how exchange rae volailiy could possibly have a negaive impac on rade volumes. However, hese models were dependen on resricions ha are considered oo rigid for an indusrialised counry like Ausralia. The following sub-secions will involve relaxing hese assumpions and analysing he resuling impac on rade volumes Hedging Opions Broll (1994) considers he possibiliy of hedging by using forward conracs and opions in he presence of a forward exchange marke. Furhermore, i is assumed ha capial invesmens are usually made before producion begins and he firm finances is capial invesmens using is own resources and by borrowing in he capial marke. Under hese assumpions, he auhor analyses he economic behaviour of a risk-averse firm producing in a foreign counry facing random exchange raes. I is found ha exchange rae volailiy only affecs he level of hedging. The level of foreign producion and capial allocaion only depends on he forward rae. In his case, he heoreical model finds ha exchange rae volailiy does no influence rade volumes. In oher sudies, Ehier (1973) and Baron (1976) also concluded ha wih perfec forward markes and he only source of uncerainy coming from he exchange rae, he volume of rade is unlikely o be affeced by exchange rae volailiy. On he oher hand, Viaene and de Vries (1992) argued ha i is possible for rade volumes o be indirecly affeced by he spo exchange rae hrough is effec on he forward rae even when here is a forward marke. The auhors posulae ha exporers and imporers are on opposing sides of he forward marke resuling in opposie effecs on expors and 14

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