This paper examines how the dissolution of the Bretton Woods system in 1973 introduced floating exchange rates and new uncertainties for international trade. Drawing on several empirical studies, the paper reviews competing theoretical positions on whether exchange rate volatility decreases or increases trade volumes, and surveys research on the responsiveness of trade flows across developed countries. It also considers commodity markets as a testing ground for understanding exchange rate effects on undifferentiated goods, and briefly explores how volatility may indirectly affect non-traded goods prices. The paper concludes that research results remain mixed, often varying by industry and country, and suggests that technological advances may help explain why trade flows appear generally resilient to exchange rate risk.
The dissolution of the Bretton Woods system in 1973 introduced a new era for international markets. No longer would exchange rates be pegged, and the shift to floating rates changed the game for international trade and investment. The newly introduced volatility in foreign exchange markets increased the risk of uncertainty for all international transactions. Floating rates produce new complexities that have implications for any individual or organization that buys, sells, makes, or trades goods or currencies. These implications directly affect a nation's balance of trade, while also indirectly affecting the lives of individuals in one way or another.
Exchange rate volatility has produced mixed theories in academia regarding its effects on trade flows. McKenzie sparked considerable interest in the field when he published his findings in 1999. By conducting a meta-analysis, he found little statistically significant support for the claim that volatility affects overall trade volume. Since his work was published, many other scholars have produced studies with similar results, while others have found implications that tend, on the whole, to be market- and industry-specific.
The mixed results provided by these sources leave one continuing to speculate about the effects exchange rate volatility might have on trade flows. Some studies have produced evidence that when data is disaggregated to the industry level, significant effects from volatility become apparent, while other studies produce minimal evidence. However, though disaggregated market information provides more insightful views into specific markets and trade flows, the data in this area also produces mixed results.
It is important to understand the historical context of the Bretton Woods system in order to fully appreciate the current academic debate. The Bretton Woods system was enacted after the end of the Second World War, when the United States emerged as the last remaining superpower. The U.S. leveraged its supremacy as the dominant world economy, maintained the gold standard, and offered other nations the confidence needed to peg their exchange rates to the dollar. Since the dollar was the strongest currency available after the war and U.S. production levels were comparatively high relative to other economies, the U.S. was able to achieve its position as the world's dominant currency.
The U.S. maintained this position into the early 1970s, when it faced increasing pressure from expanding European and Japanese economies to abandon fixed exchange rates. This pressure, combined with an inflationary period in the United States, led to a trade deficit and a consequent outflow of gold, making the system unstable. The Bretton Woods system was finally fully dismantled in February 1973.
After Bretton Woods, floating exchange rates were thought by many to lead to a decrease in international trade activity (McKenzie, 1999). The increased risk stemming from exchange rate uncertainty was expected to result in reduced levels of trade. The assumption was that greater risk would diminish the incentive to engage in international trade. From the perspective of an individual considering such a transaction, increased risk would require a monetary premium, or the deal would simply not be beneficial. The required premium would shift the supply curve to the right, and consequently a reduced quantity of demand for the product would be realized by the producer. As an aggregate effect, this would decrease the volume of bilateral trade flows between countries.
However, an opposing theory also emerged. This theory held that increased exchange rate volatility would provide an incentive for firms to accelerate the velocity at which international transactions occurred (Hegerty, 2007). Under this view, volatility could act as a catalyst to increase the amount of trade. From the producer's perspective, if exporting were a cornerstone of the business model, producers would seek to minimize the effects of exchange rate volatility.
One method of achieving this would be to schedule transactions and currency conversions within the narrowest time frame possible. This heightened sense of urgency could then facilitate an increase in trade velocity and lead to an overall rise in trade volume — almost as if the floating exchange rate acted as a lubricant that accelerated the pace of trading mechanisms.
One study examined exchange rate volatility over an extended period, using monthly data from January 1974 to July 2000 to assess effects on imports in the UK (Cheong, 2004). The study found a statistically significant negative correlation between the risk associated with fluctuating exchange rates and import trade to the UK. This is significant because a substantial portion of the UK's trade involves other members of the European Union. Furthermore, the study suggested that if the UK were to adopt the euro, it could potentially benefit by mitigating this negative correlation through use of a single currency. However, this would only reduce risk on one front; the pound's volatility against other currencies, such as the dollar, would remain.
Another dimension of the exchange rate debate concerns how quickly trade flows respond to a change in exchange rates. A country may utilize tools such as tariffs to restrain imports or subsidies to stimulate exports; however, currency devaluation could theoretically be used to achieve a similar end. One study examined the speed at which trade flows respond to exchange rate changes across nine developed countries (Bahmani-Oskooee & Kara, 2003).
The study examined Australia, Austria, Canada, Denmark, France, Germany, Italy, Japan, and the United States. It found no single common rate of responsiveness among these countries, and that each exhibited different reactions to exchange rates over the period studied, from 1973 to 1998. Implications for foreign policy may therefore be drawn from such inquiries; however, these implications appear to be relevant only at a disaggregated, country-specific level, as no overarching international trends emerged.
"Country-specific speed of trade response to rate changes"
"Commodity-level analysis of exchange rate effects"
Cheong, C. (2004). Does the risk of exchange rate fluctuation really affect international trade flows between countries? Economics Bulletin, Vol. 6, No. 4, pp. 1–8.
Hegerty, M. B.-O. (2007). Exchange rate volatility and trade. Journal of Economic Studies, 34(3), 211–255.
McKenzie, M. D. (1999). The impact of exchange rate volatility on international trade flows. Journal of Economic Surveys, 13, 71–106.
Tokarick, S. (2008). Commodity currencies and the real exchange rate. Economics Letters, 60–62.
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