Some Further Evidence On Exchange-Rate Volatility and Exports (Baru)

Some Further Evidence on Exchange-Rate Volatility and Exports
Author(s): George Hondroyiannis, P.A.V.B. Swamy, George Tavlas and Michael Ulan
Source: Review of World Economics / Weltwirtschaftliches Archiv, Vol. 144, No. 1 (April 2008),
pp. 151-180
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Some FurtherEvidenceon Exchange-Rate
Volatilityand Exports
P.A.V.B.Swamy,
GeorgeHondroyiannis, GeorgeTavlas,andMichaelUlan
Bank of Greeceand Harokopio University;
U.S. Bureau ofLabor Statistics;
Bank of Greece;U.S. Departmentof State (retired)
Abstract:The relationship betweenexchange-rate and aggregate

volatility export
volumesis examinedusinga modelthatincludesrealexportearnings ofoil-expor-
tingeconomiesas a determinant of exportvolumesof a sampleof 12 industrial
countries.Four fixed-coefficient panel-dataestimationtechniques,including
a generalizedmethodof moments(GMM) and randomcoefficient (RC) estima-
tion,are employedon panel data coveringthe estimation period 1977:1-2003:4
usingthreemeasuresof exchange-rate Our aim is to providea theoret-
volatility.
icallyand empiricallyjustifiable
specificationthatcan guideresearchers. In con-
trastto recentstudiesemploying paneldata,we findlittleevidencethatvolatility
has a negativeand significant
impacton trade.We use second-generation RC esti-
mation,whichcorrects forbiasesarisingfromincorrect functionalforms, omitted
variables,and measurement errors.Our resultssuggestthatthefindingof a sig-
nificantand negativeimpactof volatility is attributable
to specificationbiases.
JELno. C23, F3, F31
Keywords: Exchange-rate trade;random-coefficient
volatility; estimation; general-
izedmethodofmoments; paneldata
1 Introduction
A large empiricalliteraturehas investigatedthe relationshipbetween

exchange-rate and
volatility tradeflows. While the earlierliterature
(circa
1980 to the mid-1990s),employingmainlytime-series data and ordi-
naryleastsquares(OLS) estimation,did not,by-and-large, finda negative
and significant
effectof exchange-rate on aggregate
volatility tradevol-
umes,recentstudies,oftenusingpaneldataandmore-elaborate estimation
Remark:The viewsexpressedare thoseof the authorsand shouldnot be interpretedas

thoseof theirrespective
institutions.
We are gratefulto StephenHall forhelpfulcom-
ments.An anonymous referee
providedthoughtful comments and questionswhichhelped
us improvethepaper.Pleaseaddresscorrespondenceto GeorgeTavlas,EconomicResearch
Department,Bank of Greece,El. Venizelos21, 102 50 Athens,Greece;e-mail:gtavlas@
bankofgreece.gr
© 2008 KielInstitute DOT: 10.1007/sl0290-008-0141-4
152 ReviewofWorldEconomics2008,Vol. 144 (1)
techniques(fixedeffects, randomeffects, generalized methodofmoments

(GMM)) and specifications of volatility(e.g., generalizedautoregressive
conditional heteroskedasticity ( GARCH) models),haveuncovered some-
- a
thoughby no meansoverwhelmingevidenceof negative,significant
relationship.1Forexample,in a studythatsurveyed recentworkand pro-
vidednewevidence,Clarketal. (2004:3) foundthat"somerecentstudies,
as wellas someoftheevidencepresented here,appearto suggestthatthe
datasupporta negative relationship".2
This studyaimsto shedlighton thedifferences in resultsobtainedin
earlierstudies,takenas a group,andmorerecentstudies(takenas a group).
Ourpointofdeparture istheanalytic framework proposedbyBailey, Tavlas,
and Ulan (1986) (henceforh BTU). Those authorsinvestigated the rela-
tionshipbetweenexportsof the sevenlargestindustrialeconomiesand
the short-term of the exchangeratesof thecurrencies
volatility of those
economiesbased on a specification thatincludedrealexportearningsof
oil-exporting economiesas a determinant ofexportvolumes.The suppo-
sitionsunderlying thisspecification wereas follows:(1) sincethe 1970s,
oil-exporting economieshaveprovidedimportant markets forexportsof
industrialeconomies,and (2) given their levelsofeconomicdevelopment,
theincomeelasticities ofdemand(withrespectto theirrealexportearn-
ings)oftheoil exporters forindustrial-country exportsmightwelldiffer
fromtheincomeelasticities ofdemandforthosegoodsin otherindustrial
countries. BTU foundthatoil-exporters' elasticity ofdemand(withrespect
totheirrealexportearnings)forindustrial-country exports wasstatistically
In
significant. light of the large fluctuations in oil prices(and hencein
revenuesfromoil exports)in recentyears,theinclusionofsucha variable
appearsto be especiallyappropriate in presentcircumstances. Usingtwo
measuresofunconditional exchange-rate volatility,involving theabsolute
valuesof quarterly percentage changesin effective exchangeratesof the
countries concerned, BTU found no evidence of a negativeand significant
1 In some cases, recentauthorsfounda and positiverelationship between

significant
exchange-rate and tradevolumes.Surveys
volatility ofearlierliteratureincludeIMF (1984)
and Edisonand Melvin(1990).The morerecentliterature is surveyedbyMcKenzie(1999),
Clarket al. (2004), and Coricand Pugh(2006). The latterstudyfoundthat,of 49 studies
surveyed,29 studiesreported thatexchange-rate reducestrade.
volatility
~ The authorsof that thatsucha negativerela-
studywerecarefulto pointout,however,
tionshipwas notrobustto all specifications
theyestimated. In his survey,
McKenzie(1999)
foundthatthe authorsof recentpapersappearedto be havinggreater
similarly tendency
to obtainsucha [i.e.,negative]relationship.
Hondroyiannis/Swamy/Tavlas/Ulan: and Exports
Volatility
Exchange-Rate 153
effect ofvolatilityon tradeforthesevenindustrial countries consideredin

theirstudy.
Thispaperdealswiththefollowing issues:
(i) To whatextentwereBTU's resultsdrivenbythoseauthors'choiceof
a particularset of sevencountriesand a particularestimationtech-
nique (i.e., OLS)? To addressthisissue,we followthe recentlitera-
tureby applyingconstant-coefficient panel-dataestimation methods
to theoriginalgroupofsevenindustrial countriesstudiedbyBTU as
wellas to an expandedgroupof 12 industrial countries.Specifically,
we use common-fixed-coefficient estimation, fixed-effects
estimation,
random-effects estimation, and GMM estimation appliedto a panel-
data set.The GMM approach,proposedbyHansen(1982), does not
requiredistributional assumptions, such as normality, can allow for
heteroskedasticity and serial correlation of unknown form in exactly
identifiedcases,inwhichthenumberofmomentequationsis thesame
as parameters to be estimated(Greene2003: 548), and purportedly
can correct fortheeffects ofspecification errorsincludingomissionof
relevantvariables(Verbeek2004:148-153).3
(ii) Muchoftherecentliterature has usedconditional suchas
volatilities,
GARCH,to proxyexchange-rate To whatextenthaverecent
volatility.
findings ofa significant impactofvolatility on tradebeen influenced
the
by particular measure of used?
volatility To helpanswerthisques-
tion,we employa GARCH measureof volatility in additionto the
unconditional measuresusedbyBTU.
(iii) WereBTU's findings drivenbytheparticular model(involving export
earnings of oil exporters as an explanatory variable)used?To examine
thisissue,we droppedthevariablerepresenting realexportearningsof
oilexporters andre-estimated regressions under eachoftheestimation
techniques employed.
(iv) Whatare theeffects of specification biasesin a particularmodelon
the resultsobtained?To addressthisissue,we use randomcoeffi-
cient(RC) estimation. The RC approachdealswithfourmajorspe-
cificationproblems(discussedin Changet al. 2000) thatalmostal-
ways arise in econometric estimation.4 RC estimationcomesin two
varieties:first-generation and second-generation models(Swamyand
3
Havingsaid that,theassumptions theGMM approachare questionedbelow.
underlying
* For discussionsof RC estimation,
see Swamyand Tmsley(1980), Swamyet al. (2003)
and Swamyand Tavlas(2001,2005,2006,2007).
Tavlas2001). First-generation
modelscorrectformisspecifications of
functionalforms.Second-generation models takeas theirpoint of
departurethepremisethat,although onecanneverbe surethata "true"
model(inthiscase,the"true"modelofthedeterminants ofa country's
exports) RC
exists, estimation,bycorrecting forfactors
that causespu-
riousrelationships the
(e.g., effects
ofomitted incorrect
variables, func-
tionalforms,and measurement can
errors), findthe most-reasonable
approximations tothe"true"valuesoftheidentifiable
coefficientsofthe
butunknown,
"true", model.5In whatfollows, we applybothvariants
of RC estimation.As we discussbelow,use of second-generation RC
estimationprovidesa basisto searchfora specificationthatperforms
wellin bothexplanation andprediction(Zellner1988).
Brieflyto anticipate,usingthe fixed-coefficient panel-datamethods
commonly appliedin therecentliterature, we findno evidenceofan effect
ofexchange-rate on
volatility exports of the countriesconsidered, regard-
less ofthemeasureofvolatility used. However,usinga specification that
drops thevariable real
representing exportearnings ofoil exporters,we find
someevidenceofa significant and negativeeffect ofvolatility whenusing
GMM estimation and a GARCH measureofvolatility, a resultconsistent
withthatfoundin muchoftherecentliterature. Whichspecification, then,
thatwiththevariablerepresenting exportearningsofoil exporters or that
withoutthatvariable, is theappropriate one?To helpdiscriminate between
thespecifications,weuseRC estimation. Second-generation RC estimation
is particularlysuitablein thiscase becauseit directly confronts omitted-
variablesbias;ifexportearnings ofoil exporters arean appropriate variable
in thetradeequations,itsomissionis dealtwithundersecond-generation
RC estimation in thatthe"true"coefficients on theincludedexplanatory
variablesarecaptured. Wefindthattheeffect ofvolatilityon exportvolumes
is notsignificantunderRC estimation, suggestingthatthefinding ofsuch
a significant
effectelsewhere intheliteratureis attributableto specification
biasesnot capturedin constant-coefficient panel estimation procedures,
suchas GMM.
The remainder ofthispaperconsistsof six sections.Section2 briefly
summarizes recentstudiesthatuse panel-dataestimation. Section3 is an
5 The coefficients
of the"true"modelare treatedas the"true"coefficients
whichare free
fromincorrect-functional-form, and measurement-error
omitted-variable, biases.Onlythe
"true"coefficients
on theexplanatoryvariablesincludedin a specified
modelare identifi-
able on thebasisoftheavailabledata (Swamyand Tavlas2006:419, 2007).
Volatility
Exchange-Rate 155
overviewof the theoretical betweenexchange-rate

relationship volatility
andtrade.Section4 discussesthemodelanddata.Section5 providesa brief
oftheestimation
description Section6 presentstheempirical
techniques.
results.
Section7 concludes.
2 LiteratureReview
Previousstudiesemployingpanel data have tendedto findevidenceof

a negativeand statistically significantrelationship betweenexchange-rate
and trade.Wei (1999) estimated
volatility a panelof63 countriesoverthe
years 1975, 1980, 1985, and 1990; he examined a totalofover1,000coun-
trypairs.Usingswitching the
regressions, author foundthat,forcountry
pairswith largepotentialtrade,exchange-rate had a negativeand
volatility
significanteffectonbilateral tradeamongthecountries considered. Dell'Ar-
iccia(1999) examinedtheeffect ofexchange-rate volatilityon thebilateral
tradeofEuropeanUnionmembersplusSwitzerland overtheperiod1975-
1994 usingseveraldefinitions of volatility.In the basic OLS regression,
exchange-rate had a small- butsignificant
volatility - negativeimpacton
trade;reducingvolatility to zero in 1994wouldhave increasedtradeby
an amountrangingfrom10 to 13 percent,dependingon themeasureof
used.Usingbothfixedand randomeffects,
volatility he foundtheimpact
ofvolatility was stillnegativeand significant, but smallerin magnitude.
The authorfoundthatelimination ofexchangeratevolatility wouldhave
increased tradebyaboutthreeand a halfpercentin 1994.Rose(2000) also
obtainedsimilarresultsemploying a gravity model.His datasetconsisted
of 186 countriesforthe fiveyears1970,1975,1980, 1985,and 1990. In
his benchmark results(withoutrandomeffects), he foundthatreducing
volatility
by one standard deviationwould increasebilateral tradebyabout
13percent.Usingrandomeffects also,he founda smallerbutstillsignifi-
cantnegativeeffect; reducingvolatilityby one-standard deviationwould
increasebilateral tradebyaboutfourpercent.In general, Rose'sresultsare
consistent withthoseofDelFAriccia.
Tenreyro (2004),however, castsomedoubton therobustness ofRose's
results.
Usingannualdatafrom1970-1997on a sampleof 104 (developed
and developing)countries,and employinga gravitymodel that took
endogeneity into account,she foundthatvolatility had an insignificant
effecton trade.Clarketal. (2004) appliedthegravity modelusinga battery
ofestimation techniques - includingfixedand randomeffects - to a panel
of 178International
Monetary Fund(IMF) membersusingeveryfifth year
from1975-2000.Usingbothcountry- and time-fixed theauthors
effects,
founda negative impactofexchange-rate
andsignificant on trade;
volatility
a one-standarddeviationfallin exchange-rate raisedtradeby
volatility,
sevenpercent.Allowingfortime-varying randomeffects, however, a nega-
wasnotevident.Theauthorsconcludedthat,whilethereis
tiverelationship
evidencethatincreased
exchange-rate reducesthevolumeoftrade,
volatility
thisfindingdependson theparticularestimationtechniqueemployed.
3 AnalyticalConsiderations
The argument thatexchange-rate reducestradetypically

volatility runsas
follows.6In a two-country context, consider a firm located in countryA
thatsellsitsproductin country В (as wellas in country A). Forsimplicity,
suppose that thefirm sellsin a forward market in eachcountry so thatthe
firmknowsthefuturepriceofitsproductat thetimeit incursitscostsof
production. However,ifthereis no futures or forward marketforforeign
exchange,the firmhas an exchangeriskforthe futureconversion of its
salesrevenues fromcountry В intothecurrency ofcountry A. Ifthefirmis
risk-averse,itis willingto incursomeaddedcostto avoidthisrisk,so that
therisk,ifnothedged,is an implicit cost.In thepresenceofsucha cost,this
reasoningsuggests thatthefirm'ssupplypriceat each quantityof export
salesishigherthanintheabsenceoftherisk.Forsuchfirms intheaggregate,
thequantity ofexportssuppliedata givenpriceis smallerwiththisriskthan
withoutit.The samereasoningappliesto firmsin country B. Iftheriskis
presentforfirms in bothcountries, thesupplycurveforexportsfromeach
country to the other is shifted to theleft,comparedwiththosethatwould
existintheabsenceofexchange-rate risk.Tradeis reducedin a waysimilar
to thatresulting froman increaseintransportation costs.
Wherethereis a forwardmarketforforeignexchange,a discountof
theforward exchangeratein one direction, belowtheexpectedfuture rate,
is a premiumin the otherdirection.Thus,if expectations are similarin
thetwocountries, sucha discountcannotbe a deterrent to tradein both
directions.However,thebrokerage cost(spread)forforward transactions
6 For recentdiscussions, see McKenzie(1999) and Clarket al. (2004). The discussionin
thetext,draws,in part,and expandson thosestudiesas wellas on thestudiesby Bailey
(1993),and De Grauwe(2005).
et al. (1987),Delias and Zilberfarb
Volatility
Exchange-Rate 157
is generally thanthatforspottransactions
greater in foreign
exchange, and
thespreadis an increasingfunction ofthevariabilityoftheexchangerate.
Hence,theriskcan be hedgedonlyat a cost;theexistenceof forward or
futuresmarketsforforeign exchange doesnotchangethethrust oftheabove
argument although it reducesitsquantitative
significance.
Thearguments, however, arenotallon oneside.Considerthefollowing
whichsuggest
factors, thatexchange-rate can increasetrade:
volatility
(i) Exporters maygainknowledgethroughtradethatmighthelp them

anticipatefutureexchange-rate movements betterthancantheaverage
participantintheforeign-exchange market. Ifso,theprofitabilityofthis
knowledge couldbe usedto offset theriskofexchange-rate If
volatility.
exporterswish to hedgelonger-term investment or other transactions,
ratherthanuse theforward-exchange market, theycan borrowand
lendinlocalcurrency theirothercommitments.
to offset Forexample,
a plantin a foreigncountry can be financed mainlywithlocal capital,
so thatinvestorslimittheirexchangeriskin thebasicinvestment.
A
(ii) counterargument ofespecially greatweightis thatone mustspecify
thealternativeto exchange-rate Ifthevolatility
volatility. is attributable
to fundamental factors'influencing the exchangerate,intervention
by the authorities to reduceit would be unsustainable and eventu-
allydisruptive.To achieve a reduction of apparent, observed volatility,
authoritieswouldhaveto intervene withexchangecontrolsor other
restrictionson tradeand payments. That intervention could reduce
thevolumeoftrademorethanwouldunrestrained movementofthe
exchange rate.
(Hi) For countriesthathold foreign-currency balances,variability of an
exchange ratedoes not measure the effectadded amounts ofthat foreign
currency have on the overallriskinesson the firm'sassetportfolio.
The latterriskeffect dependson the covarianceof an exchangerate
withthepricesof thefirm'sotherassetsas wellas theown variance
of theexchangerate.In particular, thefirmmayhold a portfolioof
severalforeigncurrencies, thereby diversifying therisk.Ifvariations in
one currency's rate
exchange against the home are
currency negatively
correlatedwiththevariations inothers, itsvariability
reducesportfolio
risk,ratherthanincreases itwhenthatcurrency isaddedtotheportfolio.
In general,variancebyitselfdoesnotmeasuretheexchangerisk.
(iv) If firmscan adjustfactorinputsin responseto movementsin the
exchangerate,increasedvariability maycreateopportunities to raise
Thatis,movements
profits. in exchangeratesrepresent notonlyrisk,
butalsopotentialreward.Ifa firmadjustsinputsto bothhighandlow
pricesofexportsinordertotakeadvantage ofprofitopportunities when
high,itsexpected(oraverage)profits
pricesarerelatively willbe higher
thehigheris exchange-rate because
volatility the firm can sell more
whenthepriceis highand lesswhenthepriceis low.Ifriskaversionis
low,thepositiveeffect
relatively ofgreater on expected
pricevolatility
profitsmayoutweighthenegativeimpactofhigherprofits stemming
fromtheuncertainty associatedwithexchange-rate and the
volatility,
firmwillproduceand exportmore(Clarket al. 2004: 4; De Grauwe
2005:69-75).AspointedoutbyDe Grauwe(2005:73),exporting goods
canbe viewedas an option,thevalueofwhich,riseswhenthevolatility
oftheunderlying assetincreases;whentheexchange ratebecomesmore
favorable,thefirmexercisesits to
option export.
In thelightof the foregoing the issue of the relationship
arguments,
betweenexchange-rate andtradeappearstobe an empirical
volatility ques-
we describetheapproachtakenin thispaper.
tion.In whatfollows,
4 The Model and the Data
(withone exception)is ofthe

FollowingBTU (1986),themodelestimated
form:
following
logХц = logaY+ a2logYífř+ a3logRPiit+ a4logOPt
whereXířis thevolumeofexportsofindustrial country ¿,Yířis realGDP

ofindustrial-countrytrading-partner nations,RPitis a measureofrelative
of of
prices exports country i to thoseof itstrading partners,OPtrepresents
realexportearningsof oil-exporters, V¿ir is realexchange-ratevariability,
andегЛisa random-error term,andtindicates time.Theparticularcountries
consideredin constructing measuresofX, Y,RP,and OP, arelistedbelow.
In equation(1), thecoefficients are assumedto be constants. This strong
assumption is relaxedin RC estimation. the
Furthermore, assumptions
about the relationship betweenei>tand the explanatory variablesin (1)
shouldbe basedon thecorrectinterpretation ofe^. Suchassumptions are
used in RC estimation (Swamy and Tavlas 2001). As discussedin the next
Volatility
Exchange-Rate 159
section,RC estimation doesnotadd an arbitrary errortermtoa mathemat-

icalequationto obtainan econometric modelas is donein (1).
Usingquarterly time-series data overtheinterval1973:1-1984:3,BTU
(1986) estimatedtime-series regressions based on the above model (1)
foreach of the G-7 economies - Canada, France,Germany, Italy,Japan,
the UnitedKingdom,and the UnitedStates.UsingOLS, correcting for
autocorrelation wherenecessary, and employing two measuresof nomi-
nal exchange-ratevolatility,theyestimated a totalof22 regressions.7 The
authorsdidnotfinda singleinstance ofa negative andsignificant coefficient
on theexchange-rate volatilitytermin anyoftheirregressions.
This studyappliesthe above modelto 12 industrialeconomies - the
G-7 economiesplus those of Ireland,the Netherlands, Norway,Spain,
and Switzerland. The data frequency is quarterly and the sampleperiod
is 1977:1-2003:4.All data comefromtheInternational FinancialStatistics
(IFS).8In what follows,we describe these data.
The dependent variablesin theestimated equationsaretherealexports
ofthecountries considered. Thereareproblems involved indevising proxies
fortheindependent variables.Theory tellsus thatincome intrading-partner
nationsshouldaffect a country'sexports.To construct an incomevariable
fortradingpartners, we proceededas follows.RealGDP dataareavailable
intheIFS fortheperiodcoveredbythisstudyforthefollowing 11 countries:
Australia,Canada,France,Germany, the
Italy,Japan, Netherlands, Spain,
Switzerland, theUnitedKingdom,and theUnitedStates.9The exporting-
country trading-partner incomevariableforIrelandandNorway(forwhich
quarterly GDP datawere notavailableovertheentiresampleperiod)was
constructed byconverting therealGDP dataforthe11 countries listedabove
toU.S.dollarterms usingyear-average 1998exchange ratesandsumming the
dataforall 11 countries.Foreachofthetenothercountries (i.e.,otherthan
IrelandandNorway)thatis thesubjectofthisinvestigation, theindustrial-
country trading-partner income variable is constructed bysubtracting the
dollar-denominated realGDP data forthecountryin questionfromthe
7 the authorsused the absolutevalue of the quarter-to-
Specifically, quarterpercentage
changein thenominaleffective The variablewas
exchangerateas a measureof volatility.
used in both its currentperiodformand as an eight-period, second-degreepolynomial
lag.
Data seriesthatwerenot seasonallyadjustedin theIFS weretestedforseasonaladjust-
mentusingtheCensusXI 1 program(multiplicative option);thosethatdisplayedseason-
alitywereseasonallyadjustedforuse here.
9 The choiceof boththe countriesand the sampleperiodwas constrained
particular by
data availability.
11-country sum,e.g.,theindustrial-country trading-partner incomevari-

able forSwitzerland is thedollar-denominated 11-country aggregate GDP
minusthedollar-denominated realGDP forSwitzerland. Theseserieswere
employedas our industrial-country trading-partnerincomevariable,Y^.
In orderto aggregate nationalGDP series,itwasnecessary to convert them
to a commoncurrency; we chosetheU.S. dollar.However,we wantedto
ensurethatour incomevariableswereaffected byonlychangesin realin-
comesinpartner nations;wedidnotwantthevariablestobe affected bythe
changing foreign-exchange value ofthedollar.Thus, we converted all GDP
datato dollarsat a setoffixedexchangerates.We valuedtrading-partner
incomein U.S. dollarsat average1998exchangerates.
While industrial-country tradingpartnerspurchasethe bulk of the
exports of the countries under studyhere,since 1973,the oil-exporting
countrieshave been majorpurchasers of the exportsof theseindustrial
countries.Sincetheoil-exporters tendto be at a differentstageof devel-
opment from thatof the industrial-country tradingpartners, however, it
is possiblethatoil-exporters' incomeelasticitiesofdemand(withincome
proxiedby theirexportearnings)forimportsfromindustrialcountries
differfromtheincomeelasticities ofindustrialcountries. Accordingly, the
oil-exporter "income" (i.e., exportearnings) variable enters our export
equationsseparately fromtheGDPs ofindustrial-country trading partners.
The abilityofoil exporters to purchaseforeign goodsvarieswiththereal
purchasing poweroftheirexportsratherthanthecountries'realoutputs,
and exportearningsofthesecountriescan varywiththepriceofoil even
as theirrealGDPs movein theoppositedirection. Thus,theoil-exporter-
incomevariableis thesumofthedollarvaluesoftheoil-exporters' export
earningsdeflated bythedollar-denominated exportunitvalueindexofall
industrialcountriestakenas a whole.10
the
Theoretically, relative-price variablesintheexportequationsshould
be theratioofexportpricesin countryi to thedomesticpricesofsimilar
goodsproducedbyitstrading Sincethatmeasureis notavailable,
partners.
therelative-pricevariablein our exportregressions is a real-exchange-rate
indexforeachcountry. Thisvariableis basedon unitlaborcostsin manu-
facturingandrepresents theproductoftheindexoftheratiooftherelevant
10 The countriescomprisethe IMF's oil-exporters

following compositeand are used in
constructing variableused in thisstudy:Algeria,Indonesia,Iran,
theoil-exporter-income
Iraq, Kuwait,Libya,Nigeria,Oman,Qatar,Saudi Arabia,the UnitedArabEmirates, and
Venezuela.
Volatility
Exchange-Rate 161
indicator ofthecountry considered to a weightedgeometric averageofthe

corresponding indicatorsfortwenty other industrialcounties.
Exchange-rate hasbeenmeasuredintheliterature
volatility usingeither
nominalor real(effective) exchangerates.As nominaland realexchange
ratestendto movecloselytogether, giventhestickiness ofdomesticprices
(especiallyin theshortrun), thechoice ofmeasure is not likelyto affect
the
econometric results.The decisionto engagein international transactions,
however, stretchesovera relativelylongperiodoftime,duringwhichpro-
ductioncostandimportpricesin foreign-currency termsarelikelytovary.
Thislatter suggests exchange measuredinrealterms
consideration that rates
areappropriate, andwe have,therefore, usedrealrates.11 Foreachcountry,
threevolatilitymeasuresaretested.Ourfirst twomeasures, described below,
wereusedbyBTU (1986) in termsofnominalvalues.
(1) One measureis theabsolutevaluesofthequarterly percentage change
in theexportingnation'seffectiveexchangerate
= K£f,ř- JEí.t_i)/£í,ř_i|
Af-,ř , (2)
exchangerateofthecurrency
whereE¡ttis therealeffective ofexport-
ing nationi. This measure
of is
volatility used to testfora stableand
a
responseofexportsto one-percentage-point
significant change the
in
exchangerate.
(2) A secondmeasureis thefollowing:thelog oftheeight-quarter moving
standarddeviationoftherealeffectiveexchangerate
n 8 i1/2
.
Si,t= -Effiw-Дда)2 (3)
L8 /c=i J
Boththismeasureandthepreviousmeasurecapturedelayedresponses
of exportsto exchange-rate This secondmeasureis used to
volatility.
testfora stableand significant responseof exportsto a one-percent
change in thestandard deviation.
(3) In recentyears,someauthorshaveattempted to captureexchange-rate
volatility
byusing theconditionalsecond moment as a proxy(e.g.,Chou
2000; Clarket al. and
2004;Siregar Rajan2004). The underlying idea is
thatpartofthevolatility based on pastvaluesofthe
can be predicted
exchangerate.Therefore, firmsengagedin tradewouldlikelymakean
11 In his literature between

McKenzie(1999: 85) concludedthatthe distinction
survey,
realand nominalrateshas not significantly theresultsderived.
affected
to developsucha forecast.
effort We constructed
a GARCHmeasureof
as
volatility follows:
Ei,f= oio+ ofiE¿,t_i

+ щл , (4a)
hu = a + ßu]t_x+ Yht-i > (4b)

wherethe exchangeratesare expressedin logs and щл is a random
error.The conditional
varianceequationin (4b) is a function
ofthree
terms:(i) the mean,a; (ii) news about volatility
fromthe previous
period,measuredas the lag of the squaredresidualfromthe mean
equation,u}t_x(theARCH term);and (iii) thelastperiod'sforecast
errorvariance,/ií?ř_i
(the GARCH term).12 We estimateda number
ofversionsof GARCH models.For equation(4a), lagsof up to three
periodswereused,dependingupon whether thelagsweresignificant.
A GARCH(1,1) specification superiorresults.13
generated
5 EstimationMethods
Thissectionbrieflydescribesthesixestimationtechniquesused.14We as-
webelieve,thatRC estimation
sume,realistically is likelytobe lessfamiliar
to readersthantheotherapproachesused.Therefore, we devotesomewhat
morespaceto describingtheRC procedure.
(i) Common-fixed This approachappliesOLS to the panel
coefficients.
data,allowingtheintercept and slopesof (1) to be the same forall
thecountriesandtimeperiodswe considered. Underthisassumption,
(1) maynotprovidean adequateapproximation to the"true"model
(SwamyandTavlas2001).
12 It followsfromthe of a time-varying coefficient

specification (TVC) modelbelowthat
the conditionsthatthe coefficientsof (4a) are constantand E[uij'Eijt-s-'] = 0 forall
5 > 0, mayimplymisspecificationsin (4a) (Swamyand Tavlas1994;Christouet al. 1998).
lJ
Siregarand Rajan (2004) obtainedsimilarresultsm theirstudyof Southeastern
Asian economies.These authors,as well as McKenzie(1999), mentionpotentialprob-
lemsinvolvedin ARCH-basedmeasuresof exchange-rate sincetheexchange-rate
volatility;
volatility
generatedpriorto the end of the sampleperiodincorporates knowledgeabout
the future,ARCH modelsare estimated overtheentiresampleperiod.To overcomethis
problemone wouldneed to re-estimate theARCH modelat thebeginning of each quar-
terusinginformation thatis knownto thetraderat thattime.
14
Baltagi(2001) providesa comprehensive discussionof one-wayand two-way fixedand
randomeffects modelsand theiruse in panel-dataanalyses.
Volatility
Exchange-Rate 163
(ii) Fixedeffects. Supposethatcertain unobserved country- specificvariables

thatareconstant overtimetinfluence thedependent variableof( 1) and
arecorrelated withtheexplanatory intheequation.Underthis
variables
assumption, a country-specific constant termisaddedtotheright-hand
sideof( 1) toallowtheequationcontainthecountry- variables.15
specific
In thisconnection, someauthorshaveclaimed(e.g.,Clarketal. 2004)
thatcountry-specific constanttermshelp controlforremoteness or
multilateral resistance effects. The conceptof multilateral resistance
was proposedbyAndersonand VanWincoop(2003),who definedit
as a fimction ofunobservable equilibrium priceindicesthatdependon
bilateraltradebarriers and incomesharesofthetradingpartners.
(iii) Randomeffects. If the unobservedcountry-specific variablesrepre-
sentedby a country-specific constanttermare uncorrelated withthe
explanatory variables of 1
( ) , thenthe random-effects approachspecifies
thatthecountry-specific termis a country- specificrandomelement,
similarto e^u exceptthat,foreachcountry, thereis but a singledraw
thatenters( 1) identically ineachperiod.Withrandomeffects, theerror
termhastwocomponents: thetraditional erroruniquetoeachobserva-
tionandan errortermrepresenting theextent towhichtheintercept of
the/thcountry differs fromtheoverallintercept. The compositeerror
termisnonspherical, so thatgeneralized leastsquares(GLS) estimation
is used.16
(iv) Generalized methodofmoments (GMM). Equation(1) is extendedto
includelogXlř_i,logXít_2,and logXíf_3 as additionalexplanatory
variables.A GMMisusedtoestimate thisextended equationwithlagged
independent variables as in
acting instruments; the seven-country
panel, five lags of each oftheindependent variableswereused while
in the 12-country panel threelags of each of theindependent vari-
ableswereused.Sincetherearemoreinstruments thanright-hand side
variables, the estimated regression equations are overidentified.To as-
sessthevalidity ofthedifferent we the
specifications compute Sargan
(1964) testforoveridentifying whichamountsto a testof
restrictions,
theexogeneity oftheexplanatory andARI andAR2testsfor
variables,
autocorrelation whicharelistedas m' and m2in Arellanoand Bond
(1991).
15 a time-specific
constanttermcouldbe introduced.
Additionally,
Dell'Ariccia(1999) claimsthatuse ofbothfixedand randomeffectscan helpdeal with
problems.The Swamyand Arora(1972) estimators
simultaneity of the componentvari-
ancesare employed in theestimation
of therandom-effects
equations.
Eachofthefouraboveestimation techniques imposesassumptions that

can be difficultto fulfill.
Common-fixed-coefficients estimation assumes
thattheintercept and slopesarethesameforallcountries andtimeperiods.
Wehavealready noted theseriousimplications stemming theassump-
from
tionsmadebycommon-fixed-coefficients estimation. Withregardtofixed-
effectsestimation, forconsistentestimation of (1) usingtheOLS method,
a necessaryconditionisthatthecountry-specific variablesandtheincluded
explanatory variablesin (1) areindependent ofeí?ř.Underrandomeffects,
a necessaryconditionfortheGLS estimator ofthecoefficients of (1) to be
consistentis thattheerrorcomponents areindependent oftheexplanatory
variablesin (1). GMM estimators can be inconsistent becausethereare
obstaclesin obtainingtheinstrumental variablesneededto applyGMM,
as shownby Swamyand Tavlas(2007) in theirderivation of an adequate
approximation to the"true" model. In the light ofthesefactors,we turnto
a procedure thatcan produceconsistent estimators ofthecoefficients.
(v) First-generation random-coefficient (RC) estimation. Effectively, first-

RCs
generation capture the effects of nonlinearitythrough time
the
variationofthecoefficients.
(vi) Second-generation random-coefficient (RC) estimation. In thisestima-
tion,notonlytheintercept butalsotheslopesof( 1) areallowedtodiffer
amongthecountries bothat everypointin timeand through time.In
toas "thetime-varying
thisform,( 1) isreferred coefficient (TVC) mod-
=
el".Let a'it logauj + eitty a'iv a'lv a'iv and a'it be theintercept
and the coefficients on logYi>t,logRPitt9 logOPt, Viit,respectively,
in the TVC model.Then it followsfromSwamyand Tavlas(2001)
thatwhenthe"true"modelexists, theTVC modelis itsexactrepresen-
tationwithuniquecoefficients if(i) theintercept,a'{ t,is interpreted
as thesumof(a) theintercept ofthe"true"model,(b) thejointeffect
on logXIřoftheportionsofexcludedvariables(i.e.,thedeterminants
oflogXIřexcludedfrom(1)) remaining aftertheeffects ofthe"true"
values of the explanatory variablesin (1) have been removed,and
(c) themeasurement error in logXíř,and (ii) for; = 2, 3, 4, 5, a*itis
interpreted as the sum of (a) thejth coefficient ofthe"true"model
whichis also called "thebias-freecomponent the;th coefficient
of
of theTVC model",(b) a termcapturingomitted-variables bias due
to excludedvariables,and (c) a measurement-error bias due to mis-
measuringthejth explanatory variablein (1). Theseare the correct
interpretations ofthecoefficients oftheTVC model.
Volatility
Exchange-Rate 165
We estimate theTVC modelunderthefollowing RC assumption:For

all i = 1,2, ..., n(= 7 or 12) and f = 1,2, ..., T(= 108):
alt= % + Zittn*
+ elt, (5a)
= (5b)
<r *ü<t-i+<t>
where¿z*ř = (а^а%и, ...,a*5ityyã* = (ä*f,ä*-, is a 5 x (p - 1)
..., ã*f)',Zz-,r
matrixof observations -
on (p 1) non-constant coefficient drivers,7Г*
is a (p - l)-vectorof fixedcoefficients, =
s*t (e*¡v s'{ v ..., e'{ ,)', Фц is
a 5 x 5 matrix,v*t= (v*-ř,v'lv ..., vlit)', the a* are independently dis-
= =
tributedwithmean vector,Eä* a* (a*, a', ..., Я5У,and covariance
matrix,Д, thev*řare independently distributed withmeanzeroand co-
variancematrix, is
Ацуs*t independent of a*, is
Z¿>r independent ofe*řand
й*, and is
a*t conditionally independent ofthe explanatory variables of(1),
givenZ,> Intuitively, thecoefficient drivers can be thoughtofas variables,
thatservetwopurposes.First,theydeal withthecorrelation betweenthe
includedexplanatory variables(Iog7íř, logЯРц>log OPř,V¡j) and their
coefficients in theTVC model.In otherwords,eventhoughtheincluded
explanatory variablesarenotunconditionally independent oftheircoeffi-
cients,theycanbe conditionally independent oftheircoefficients giventhe
coefficient drivers.Second,thecoefficient driversallowus to decompose
thecoefficients oftheTVC modelintotheirrespective components. Wecall
theestimation of theTVC modelunderassumptions(5a) and (5b) "the
RC estimation" becauseundertheseassumptions, theTVCs are random
variables.This RC estimation is called"firstgeneration" ifл* = О and is
called"secondgeneration" otherwise.
We mayhaveto includeappropriate coefficient driverswithnonzero
coefficients on theright-hand sideof(5a) tomaketheassumption ofcondi-
tionalindependence betweentheincludedexplanatory variablesand their
coefficients in theTVC modelhold. We decomposethe right-hand side
=
of(5a) intotwopartsso thatforj 2, 3,4, 5,onepartmeasures thejthcoef-
ficient ofthe"true"modelandtheotherpartmeasures thesumsofomitted-
variableand measurement-error biasescontainedin a* r The measureof
the;th coefficient ofthe"true"modelis an estimateofthejth coefficient
oftheTVC modelcorrected foromitted-variable and measurement-error
biases.Whenthejth coefficient ofthe"true"modelwithj = 2, 3, 4, or 5 is
zero,thecorrelation betweenlogXí?ř and thejth explanatory variablewith
=
j 2, 3, 4, or 5 in is
(1) spurious(Swamy and Tavlas 2007). We consider
bothzeroand nonzerovaluesof Фц.
6 EmpiricalResults
The following setsofregressions wereestimated. First,thefourconstant-

coefficient panel-estimation methods were appliedtotheBTU model- i.e.,
thespecification including realexportearnings ofoilexporters - usingdata
-
both forthe G-7 countries Canada, France,Germany, Italy,Japan,the
UnitedKingdom,and theUnitedStates - and fortheexpandedsetof 12
countries. Second,thesamefourconstant-coefficient estimation methods
wereappliedto the same groupsof countriesusinga specification that
excludestheexportearnings ofoil exporters.
Third,first-generation RC estimation - i.e,theRC methodemploying
onlythetimevariationofthecoefficients - was appliedto thetwosetsof
countries usingboththeBTU specification andthespecification excluding
exportearnings of oil exporters. That is,we did not use coefficient drivers
to
decompose the coefficients into their respective a
components, procedure
thatprovidesimpliedestimates ofthebias-free components (i.e.,thecom-
ponents free of omitted- variable and measurement-error biases) ofRCs.17
Thesefirst-generation RC regressions, are,however, not freeofmisspeci-
fications becausetheydo nottakeaccountofthecorrelations betweenthe
includedexplanatory variables andtheircoefficients. Aswell,intheRC envi-
ronment thedistributional assumptions made about thecoefficients inthis
RC
first-generationprocedure can be inconsistent with the"correct" inter-
pretation ofthecoefficients, whereby, under the correct interpretation,each
oftheslopecoefficients is thesumofthreeterms:(1) a bias-free compon-
ent,(2) an omitted-variables biascomponent, and (3) a measurement-error
biascomponent.Becauseeachslopecoefficient is,in fact,thesumofthese
threecomponents, thepattern of variation in each of thesecomponents
maybe inconsistent withtheassumedpattern ofvariationofthesum.It is,
therefore, important to isolate the bias-free component.
Fourth,to obtainbias-free components, we thenestimated regressions
using"coefficient drivers", whichprovidesecond-generation RC results.
As in thecase withthefirst-generation technology, thesecond-generation
was
approach applied to both model specifications withand without
(i.e.,
exportearnings of oil exporters) to both groupsof countries.Two
and
coefficient drivers wereused:zit - thechangein therealexchangeratein
-
periodt 1foreachcountry considered, thatis,thechange(inperiodt - 1)
17 Nevertheless, errorsdue to incorrect

RC shedslighton specification
first-generation
formsin fixed-coefficient
functional methods.
Volatility
Exchange-Rate 167
of each country's relative-price variable,denotedas RP in equation(1),

and Zu = thechangein exchange-rate volatilityin periodt - 1, whereby
theexchange-rate volatilitymeasureis definedaccordingto the measure
employed in a particularequation.18
In whatfollows, specifications withtheabsolute-per-cent-change mea-
sureofvolatilityareidentified withthesubscript "a",thosewiththemoving-
standard-deviation measurewiththe subscript"b",and thoseusingthe
GARCHmeasurewiththesubscript "c".FortheRC regressions, theaverage
ofthecoefficients overtheentiretimeperiodand all crosssectionalunits
arereported.
Allthereported resultsforGMM estimation areestimates ofthecoeffi-
cientsofmodel(1) withlarge-sample t-ratios.Twotypesofdiagnostic tests
wereperformed foralltheestimated equations.First, the m' and m2 for
tests
autocorrelation wereperformed. FortheBTU model,thefollowing results
wereobtained:thevaluesofnt' fortheseven-country panelwere4a: 0.15,
4b: 0.04,4c: 0.09 and forthe 12-country panel4a: 0.55,4b: 0.60,4c: 0.67.
Thevaluesofm2fortheseven-country panelwere4a: 1.66,4b: 1.49,4c: 1.64,
andforthe12-country panel -1.13,4b: -0.49,4c: -0.83. Forthemodel
4a:
thatomitsthevariablerepresenting realexportearningsof oil exporters,
thefollowing resultswereobtained:thevaluesofmi fortheseven-country
panel were 4a: -0.06, 4b: -0.10, 4c: 0.07 and forthe 12-country panel
4a: -0.70, 4b: -0.34, 4c: -0.02. The valuesof m2fortheseven-country
panelwere4a: -0.69, 4b: -0.68, 4c: -0.51, and forthe 12-country panel
4a: 0.10,4b: 0.10,4c: 0.19.None ofthesevaluesrejectsthehypotheses that
thereisno serialcorrelation intheregression disturbances. Next,theSargan
testwasperformed. FortheBTU model,thefollowing resultswereobtained:
thevaluesfortheseven-country panel were 4a: 27.93, 22.61,4c: 24.15
4b:
andforthe12-country panel4a: 10.90,4b:8.28,4c:10.79.Forthemodelthat
omitsthevariablerepresenting realexportearnings ofoil exporters,thefol-
lowing values were obtained for theSargan testforthe seven-country panel
4a: 663.10,4b: 662.50,4c: 665.20and forthe12-country panel4a: 1081.00,
4b: 1165.00,4c: 1172.00.None ofthesevaluesrejectstheoveridentiiying
restrictions.
Table1 presents regression resultsfortheseven-country panelusingthe
fourconstant-coefficient panel-data methods. For the sake in
of brevity,
18 The bias-free of thecoefficients RC modelsare esti-

of second-generation
components
matedusingtheestimator, rescaledGLS
a- +Ziijn*> whereй and 7Г*are theiteratively
estimatorsof a* and л'*, respectively, =
forj 2, 3, 4, 5.
Table 1: Panel Data EstimationofExportEquations:Seven Countries,BTU Model
Estimation Constant Industrial- Oil-exporter Real Exchange- Standard

method country export exchange rate errorof
income earnings rate volatility regression
measure
Common
fixedcoefficients
la -2.977 0.758 0.218 -0.137 -0.002 0.287575
(-1.64) (3.05) (3.26) (-0.77) (-0.34)
lb -2.891 0.75 0.217 -0.124 -0.022 0.287317
(-1.61) (2.95) (3.36) (-0.63) (-0.64)
lc -2.953 0.757 0.219 -0.141 -1.776 0.287495
(-1.60) (3.06) (3.18) (-0.79) (-0.52)
Fixed effects
2a -10.172 1.662 0.085 -0.275 0.001 0.097147
(-12.79) (18.47) (2.05) (-4.63) (0.68)
2b -10.099 1.652 0.084 -0.267 -0.010 0.097040
(-11.94) (16.61) (2.05) (-4.13) (-0.52)
2c -10.143 1.659 0.085 -0.275 -0.154 0.097175
(-12.55) (18.26) (2.06) (-4.65) (-0.14)
Randomeffects
3a -9.934 1.625 0.090 -0.257 0.001 0.110488
(-11.42) (18.06) (2.08) (-4.40) (0.50)
3b -9.859 1.615 0.089 -0.249 -0.010 0.110368
(-10.75) (16.29) (2.10) (-3.79) (-0.58)
3c -9.902 1.622 0.090 -0.257 -0.260 0.110697
(-11.24) (17.92) (2.08) (-4.40) (-0.25)
GMM estimation
4a -9.565 1.690 0.074 -0.502 0.001 0.033056
(-6.95) (14.23) (3.22) (-3.80) (0.25)
4b -9.556 1.694 0.073 -0.509 -0.005 0.032864
(-6.97) (13.02) (2.94) (-4.11) (-0.16)
4c -9.512 1.689 0.073 -0.510 -0.373 0.033014
(-6.36) (13.13) (3.17) (-3.72) (-0.05)
Note:The estimation
periodforall themodelsis 1977:1-2003:4.
The figures
in parentheses
arethet-ratios.
Table1 and in subsequenttables,common-fixed-coefficients estimation is

identified
as method1,fixedeffects
as method2,randomeffects as method3,
and GMM as method4. The following resultsmeritcomment.First,the
coefficientson thevolatility in each of the 12
variablesare insignificant
regressions Second,thecoefficient
reported. on theoil-exporter"income"
and positivein each equation,and markedly
variableis significant lower
thanthecoefficient on theindustrial-countryincomevariable,indicating
thatoilexportersandindustrialcountries havedifferent
incomeelasticities,
Volatility
Exchange-Rate 169
as hypothesized. Third,comparingthe coefficients of thethreeexplana-

toryvariablesotherthanvolatility (i.e.,industrial-country trading-partner
income,oil-exporter income,therealexchangerate)amongthefoursets
of regressions, thereis a cleardelineationbetweenthe resultsbased on
common-fixed coefficients(method1) and theresultsof theotherthree
methods. Eachoftheotherthreemethodsyieldsindustrial-country income
elasticitiesin therangeof 1.6 to 1.7,morethantwicethoseprovidedby
method1. Methods2 through4 giveoil-exporter-income elasticitiesin
therangeof 0.07 to 0.09, about one-thirdof theelasticities obtainedby
method1. Also,method1 yieldslow relative-price elasticitiescompared
withtheotherthreemethods.Finally, unliketheothermethods,method1
producescoefficients on realexchangeratevariablesthatareinsignificant.
Table2 reports theresultsofthepanelbasedon 12 countries. Again,there
is no evidencethatexchange-rate volatility reduces trade;the coefficient of
thevolatility termis insignificant in each of the 12 equationsreported.
As was the case withthe resultsbased on the seven-country panel,the
common-fixed-coefficients methodgiveslowerelasticities forindustrial-
countryincomeand higherelasticities foroil-exporter incomethandoes
each of theotherthreemethods.Comparedwiththeresultsreportedin
Table1,theresults ofmethods2 through 4 (inTable2) generally showhigher
income(both industrialcountryand oil exporter)and higherabsolute
relative-price elasticities.
To whatextentdo theresultsreportedin Tables1 and 2 reflect theuse
oftheBTU specification, which,unlikemostspecifications foundin the
literature,includesrealexportearningsof oil exporters? To shedlighton
thisissue,inthecontext ofthefixed-coefficient estimation methods, we re-
estimated eachofthespecifications containedin Table1 (sevencountries)
and Table2 (twelvecountries),but withthevariablecapturingthe real
exportearningsofoil exporters dropped.In whatfollows, we referto this
specification as the"standard" specification, sinceitcorresponds tothebasic
modeltypically usedin theliterature.19 The resultsarereported in Tables3
(sevencountries)and 4 (twelvecountries).Amongthe 24 specifications
containedin Tables3 and 4, thereis evidenceofa negativeand significant
impactofvolatility undertwospecifications - thosedenotedas 4c in each
table- thatis,thespecification estimated withGMM andusingtheGARCH
measureofvolatility. This resultis consistent withthatfoundin some of
therecent literature, whichshowssometendency toreporta significant and
19 Of course,thebasic is oftenaugmented
withadditionalvariables.
specification
Table2: PanelData Estimation

ofExportEquations:Twelve BTU Model
Countries,

measure
Common
fixedcoefficients
la -5.564 1.238 0.195 -0.480 -0.011 0.914058
(-1.36) (2.87) (2.84) (-1.18) (-1.18)
lb -5.212 1.174 0.189 -0.397 -0.110 0.912097
(-1.32) (2.91) (3.03) (-1.00) (-1.13)
lc -5.515 1.236 0.200 -0.493 -9.040 0.913945
(-1.31) (2.84) (2.89) (-1.19) (-0.84)
Fixed effects
2a -10.779 1.869 0.106 -0.553 0.001 0.139874
(-8.21) (15.08) (3.55) (-2.76) (0.20)
2b -10.649 1.851 0.105 -0.537 -0.019 0.139484
(-8.57) (15.71) (3.61) (-2.52) (-0.67)
2c -10.764 1.868 0.106 -0.553 -0.115 0.139878
(-8.05) (14.96) (3.54) (-2.76) (-0.12)
Randomeffects
3a -10.778 1.869 0.107 -0.552 0.001 0.139760
(-9.57) (15.14) (3.56) (-2.77) (0.20)
3b -10.647 1.851 0.105 -0.537 -0.019 0.139369
(-9.89) (15.77) (3.63) (-2.53) (-0.68)
3c -10.763 1.868 0.106 -0.553 -0.116 0.139762
(-9.37) (15.02) (3.55) (-2.77) (-0.12)
GMMestimation
4a -10.623 1.858 0.089 -0.629 0.001 0.051349
(-7.54) (14.96) (2.62) (-3.47) (0.50)
4b -10.586 1.856 0.091 -0.632 0.002 0.054039
(-7.74) (15.30) (2.59) (-3.27) (0.08)
4c -10.549 1.850 0.091 -0.630 -2.261 0.051411
(-7.25) (14.50) (2.71) (-3.45) (-1.02)
Note:The estimation The figures
periodforall themodelsis 1977:1-2003:4. in parentheses
arethet-ratios.
negativeimpactofvolatility whenusinga specification that:(1) includes

a GARCHmeasureofvolatility, and (2) isestimated
usingGMM (McKenzie
1999; Clarket al. 2004).
Comparing theresultsinTables1 and 2 withthosecontainedinTable3
thefollowing
and 4, respectively, findings areworthsingling-out.
First,the
coefficients
on thevariablesrepresenting income
industrial-country andthe
realexchangeratearelittlechangedwhendropping thevariablerepresenting
real exportearningof oil exporters. Second,the standarderrorsof the
Volatility
Exchange-Rate 171
Table 3: Panel Data EstimationofExportEquations:Seven Countriesy

StandardModel

measure
Common
fixedcoefficients
la -2.310 0.786 - -0.136 -0.003 0.295372
(-1.14) (3.13) (-0.72) (-0.45)
lb -2.224 0.772 - -0.120 -0.026 0.295050
(-1.10) (2.98) (-0.57) (-0.66)
lc -2.319 0.787 - -0.138 -1.531 0.295388
(-1.13) (3.15) (-0.72) (-0.45)
Fixed effects
2a -10.015 1.686 - -0.280 0.001 0.100578
(-12.66) (18.21) (-4.32) (0.41)
2b -9.942 1.676 - -0.271 -0.011 0.100408
(-11.97) (16.65) (-3.96) (-0.58)
2c -9.999 1.685 - -0.280 -0.018 0.100590
(-12.42) (18.00) (-4.32) (-0.02)
Randomeffects
3a -9.746 1.648 - -0.261 0.001 0.114776
(-11.03) (18.13) (-4.02) (0.23)
3b -9.672 1.637 - -0.251 -0.012 0.114580
(-10.50) (16.50) (-3.49) (-0.64)
3c -9.727 1.646 - -0.261 -0.124 0.114986
(-10.87) (18.01) (-4.01) (-0.11)
GMM estimation
4a -9.031 1.682 - -0.511 -0.001 0.035255
(-7.53) (14.57) (-3.43) (-0.33)
4b -9.066 1.687 - -0.516 0.003 0.035261
(-6.82) (12.40) (-3.21) (0.07)
4c -8.684 1.650 - -0.519 -9.386 0.035102
(-6.11) (13.45) (-3.28) (-2.14)
Note:The estimation
The figures
in parentheses
arethet-ratios.
regressions
reportedinTables1 and2 areslightly,butuniformly,lowerthan
thosereportedin Tables3 and 4. Thus,whilethevariablerepresenting real
exportearningsof oil exportersdoes not havemuch of an impact the
on
coefficients
oftheotherincludedvariables, thereis someevidence(interms
ofthedifferences
inthevaluesofthecoefficients on theindustrial-country-
incomeand theoil-exporter-export-earnings variables)thatit shouldbe
includedin exportequations.
ofExportEquations:Twelve
Table4: PanelData Estimation Countries,
Model
Standard
measure
Common
fixedcoefficients
la -4.652 1.241 - -0.506 -0.010 0.910664
(-1.07) (2.83) (-1.21) (-1.22)
lb -4.684 1.202 - -0.393 -0.114 0.913653
(-1.13) (2.98) (-0.97) (-1.15)
lc -4.991 1.269 - -0.490 -8.702 0.915724
(-1.12) (2.92) (-1.16) (-0.81)
Fixed effects
2a -10.644 1.897 - -0.541 0.001 0.140838
(-8.28) (15.06) (-2.65) (0.05)
2b -10.498 1.880 - -0.533 -0.021 0.143196
(-8.30) (15.58) (-2.41) (-0.74)
2c -10.631 1.900 - -0.549 0.121 0.143660
(-7.78) (14.77) (-2.64) (0.11)
Random effects
3a -10.778 1.867 - -0.541 0.001 0.140720
(-9.57) (15.12) (-2.66) (0.05)
3b -10.496 1.880 - -0.533 -0.021 0.143080
(-9.53) (15.64) (-2.42) (-0.75)
3c -10.630 1.900 - -0.549 0.119 0.143543
(-9.02) (14.82) (-2.65) (0.11)
GMM estimation
4a -8.611 1.839 - -0.920 0.011 0.038999
(-5.42) (13.23) (-6.30) (1.67)
4b -8.510 1.874 - -0.985 0.058 0.038961
(-5.24) (11.15) (-5.94) (1.06)
4c -7.781 1.783 - -0.942 -12.557 0.038916
(-4.56) (11.55) (-6.30) (-2.33)
The figures
Note:The estimation in parentheses
arethet-ratios.
At thispoint,a briefsummaryof theabovefindings maybe helpful

we
in settingthe stageforwhat follows.Usingthe BTU specifications,
foundno evidenceof an of
impact exchange-rate on
volatility exports
underanyofthefourconstant-coefficient panel-datamethodsemployed.
When we dropped the variablerepresenting real exportearningsof
oil exporters,we foundevidenceof a significant and negativeimpact
ofvolatility bothusingGMM estimation
in onlytwo specifications, and
Volatility
Exchange-Rate 173
a GARCH measureof volatility. How do we discriminate amongthese

specifications?
To addressthisissue,we turnto RC estimation, which,as noted,cor-
rectsforthespecification biasescontainedin fixed-coefficientprocedures.
WeapplyRC estimation in twosteps.First,we use first-generationRC esti-
mation, which,although itdoes not correct forbiasesattributable
toomitted
variablesand measurement errors,does correctforfunctional-form mis-
specificationsfoundin fixed-coefficient procedures. Second,we thenapply
second-generation RC estimation, which correctsforbiasesattributableto
incorrect functionalforms, omitted variables,and measurement errors.The
twoRC procedures areappliedtobothdatasets- i.e.,to theseven-country
and 12-country panels- and to bothmodels- i.e.,theBTU and standard
models.
Tables5 and 6 reportRC resultsfortheseven-country paneland the
12-country panel,respectively.Each table consistsof 12 rows. Rows 1
through3 giveresultsforfirst-generation RC appliedto theBTU model,
whilerows4 through6 giveresultsforfirst-generation RC appliedto the
standard model.Rows7 through 9 provideresults forsecond-generation RC
appliedtotheBTU model,whilerows10through 12givesecond-generation
RC appliedtothestandard model.In thesetables,first-generationspecifica-
tionsaredenotedas RC1 and second-generation specifications denoted
are
as RC2. As in theprevioustables,subscripts "a","b",and "c" referto the
volatilitymeasuresused.
The following resultscontainedin Table5 (seven-country panel) are
worthnoting.First,in comparing theBTU modelwiththestandardmodel
usingfirst-generation RC technology (i.e.,rows1-3 and 4-6, respectively),
thereis no evidenceof a significant volatility In fact,the high-
effect.20
est absolutevalue of the t-ratiosis providedby the GARCH measure
of volatilityin the standardmodel (row 6), but it is positive;at 1.63,
at the 10 per centlevel.Second,similarconclusions
it is not significant
applyusingsecond-generation RC technology; thehighestabsolutevalueof
20 Nevertheless, the RC approachdoes not drop a variableunderthe conditionthatits
coefficientis insignificant.
A fulltreatment of RC estimation assesseswhetherthe inclu-
measurein (1) couldbe reducingomitted-
sion of a volatility variableand measurement-
errorbiasescontainedin the coefficients of the equationcomparedto whattheywould
havebeen in the absenceof a volatility measure.In otherwords,the factthata volatil-
itymeasureis insignificant and contributes littleto the coefficient
of determinationdoes
notin itselfprovidegroundsforexcluding thevariable.The conditionsneededto pursue
thislineofresearch areverydifficultto implement in RC estimation usingpaneldata and
we leavethisresearch fora futureline of work.
ofExportEquationsUsingRC Estimation:
SevenCountries
measure
RC: BTU model

First-generation
la (RC1) -9.559 1.627 0.082 -0.336 -0.001 0.000324
(-12.33) (16.48) (1.98) (-3.36) (-0.35)
2b(RCl) -9.211 1.604 0.080 -0.356 -0.014 0.000332
(-10.00) (14.88) (2.11) (-3.19) (-1.05)
3c(RCl) -10.074 1.659 0.084 -0.294 -13.394 0.000322
(-13.01) (14.65) (1.91) (-3.20) (-0.59)
RC: standard model
First-generation
4a(RCl) -9.139 1.632 - -0.357 -0.001 0.001074
(-9.28) (14.82) (-2.85) (-0.61)
5b(RCl) -8.863 1.607 - -0.361 -0.026 0.000655
(-7.31) (13.07) (-2.58) (-1.52)
6c (RC1) -9.791 1.704 - -0.370 23.130 0.000554
(-8.41) (12.87) (-3.36) (1.63)
Second-generationRC: BTU model
7a(RC2) -9.435 1.629 0.079 -0.361 -0.001 0.000310
(-10.96) (15.85) (2.01) (-3.35) (-0.08)
8b(RC2) -9.040 1.603 0.077 -0.387 -0.027 0.000210
(-6.98) (12.46) (2.56) (-2.77) (-0.85)
9c(RC2) -9.956 1.651 0.083 -0.301 10.667 0.000043
(-15.10) (16.05) (1.95) (-3.34) (0.94)
Second-generationRC: standard model
10a (RC2) -9.041 1.632 - -0.380 -0.001 0.000760
(-7.96) (14.08) (-2.73) (-0.28)
llb(RC2) -8.716 1.603 - -0.384 -0.027 0.000561
(-5.47) (11.23) (-2.27) (-1.30)
12c (RC2) -9.816 1.717 - -0.380 -21.377 0.000356
(-11.81) (13.02) (-3.12) (-1.43)
Note: The estimationperiod for all the models is 1977:1-2003:4. In the second-generation
RC model two coefficientdriversare used: change in the real exchangerate in period t - 1
and change in exchange-ratevolatilitymeasurein period г - 1. The estimatedcoefficientsof
second-generationRC models are estimatedusingthe changein real exchangeratein the pre-
vious period. The figuresin parenthesesare the t-ratios.
is obtainedusingthe standardmodel and the

the t-ratioson volatility
GARCH volatility measure;the t-ratiois -1.43, but is not significant.
Third,thecoefficientson realincome,realexportearnings, and thereal-
exchange-ratevariable are similar
to the results in
reported theprevious
tables.
Exchange-RateVolatilityand Exports
Hondroyiannis/Swamy/Tavlas/Ulan: 175

ofExportEquationsUsingRC Estimation:
TwelveCountries
measure
RC: BTU model

First-generation
la(RCl) -11.497 1.840 0.101 -0.337 -0.001 0.000359
(-10.13) (13.76) (3.60) (-3.04) (-0.23)
2b(RCl) -11.415 1.826 0.099 -0.321 -0.012 0.000361
(-9.22) (13.34) (3.90) (-2.91) (-0.82)
3c(RCl) -11.802 1.867 0.103 -0.326 -7.019 0.000387
(-11.08) (13.89) (3.38) (-3.38) (-0.32)
RC: standard model
First-generation
4a(RCl) -11.334 1.844 - -0.287 -0.001 0.001282
(-8.79) (13.72) (-2.34) (-0.66)
5b(RCl) -11.188 1.820 - -0.265 -0.022 0.000817
(-8.23) (13.55) (-2.02) (-1.83)
6c(RCl) -11.757 1.884 - -0.277 -4.048 0.000650
(-9.12) (13.15) (-2.45) (-0.21)
Second-generationRC: BTU model
7a(RC2) -11.441 1.842 0.100 -0.353 -0.001 0.000306
(-9.44) (13.59) (3.62) (-2.96) (-0.04)
8b(RC2) -11.308 1.824 0.099 -0.341 -0.013 0.000283
(-8.05) (12.98) (4.49) (-2.58) (-1.11)
9c(RC2) -11.702 1.858 0.100 -0.328 -8.651 0.000038
(-9.57) (12.44) (3.53) (-2.62) (-0.46)
Second-generationRC: standard model
10a (RC2) -11.315 1.847 - -0.297 -0.001 0.000930
(-8.07) (13.47) (-2.22) (-0.56)
llb(RC2) -11.145 1.822 - -0.278 -0.023 0.007466
(-7.08) (13.17) (-1.77) (-1.63)
12c (RC2) -11.683 1.882 - -0.288 -5.256 0.000370
(-8.05) (11.60) (-2.35) (-0.26)
Note: The estimationperiod for all the models is 1977:1-2003:4. In the second-generation
RC model two coefficient driversare used: change in the real exchangerate in period t - 1
and changein exchange-ratevolatilitymeasurein period t- 1. The estimatedcoefficients of
second-generation RC models are estimatedusingthe changein real exchangeratein the pre-
vious period. The figuresin parenthesesare the t-ratios.
In Table6, thereis one measureof the coefficienton exchange-rate

that
volatility is and
negative significantat thetenper centlevel(though
notat thefivepercentlevel).The particular
measureis theeight-quarter
movingstandard deviationinthestandard
modelusingfirst-generationRC
technology,as reportedin row5b ofthetable.Recall,however,thatfirst-
generation RC estimation doesnotcorrect foromitted-variables biasand/or

measurement-errors bias. Consequently,theforegoing resulton volatility
couldreflect specification biasesstemming fromomittedvariablesand/or
measurement errors. To addressthisissue,considerthesecond-generation
RC resultappliedto thesame specification - thatis, thestandardmodel
usingtheeight-quarter movingstandarddeviationmeasureofvolatility. As
reported in row lib, the coefficient
on the measure of remains
volatility
negativeand theabsolutevalueofthet-ratiofallsto 1.63 (comparedwith
1.83usingfirst-generation RC technology); the 1.63t-ratiois not signifi-
cantat thetenpercentlevel.Thus,theRC resultsprovidesomeevidence
of specificationbiasescontainedin coefficients thatare not corrected for
omitted variablesand/ormeasurement errors.
Severalotherfeatures, to thestandarderrorsoftheregres-
pertaining
sions (SERs), of Tables1 though6 are worthmentioning. (See the final
columnsof the tables.)First,thereis a markedtendencyin each of the
firstfourtablesfortheSERsto fallsharply in movingfromcommon-fixed-
coefficientsestimationto eitherfixedeffects or randomeffects. Second,
GMM estimation provides much lowerSERs than any ofthe other constant-
coefficientmethods.Third,theRC methodsprovidemuchsmallerSERs
thanGMM.
7 ConcludingRemarks
As discussedabove,somerecentstudies,usingpaneldata,foundevidence,
but by no meansoverwhelming, of a significantand negativeimpactof
exchange-rate on
volatility trade. Although it is difficult
to drawgener-
alizationsfromthisfinding, twofactorsseemto be of importance. First,
as notedbyMcKenzie(1999) in hisliterature survey, theuse ofa GARCH
- typicallyGARCH (1,1)- of volatilityseems to produce
specification
effectsofvolatility
on tradethataremore-consistently negative and signifi-
cantthanotherspecifications.Second,studiesemploying paneldatatended
to findnegativeand significant effectsofvolatilityon trade,regardless of
themeasureofvolatility employed.
This paper has investigated the followingissue: in the lightof the
widediversity ofspecifications
and accompanying resultscontainedin the
literature a
concerning relationship between exchange-rate and
volatility
trade,howcan a satisfactoryor adequatespecification be determined. Our
approachin dealingwiththisissueproceededas follows.
Volatility
Exchange-Rate 177
Webeganbyestimating theBTU model,a specification appliedin the

literaturesometwenty yearsago to seven large industrial countries. The
distinctivefeatureofthismodelis theinclusionofrealexportearningsof
oil-exporting economies.BTU'sdatasetwasupdatedand expandedto also
includefiveadditional industrialcountries.TheBTU modelwasgeneralized
to includea GARCHmeasureofexchange-rate It was estimated
volatility.
using four constant-coefficientpanel-data estimation methods. Wedidnot
findanyevidenceofa negativeand significant impactofvolatility on trade
using panel-data setsconsisting of sevenand twelve economies.
Wethencarriedouta further investigationwhereby wedroppedthevari-
able representing real export earningsof oil exporters,providing
a "standard" modeloftherelationship betweenexportsand volatility. We
foundevidenceofa negativeand significant impactofvolatility on trade
whenestimating withGMM and usingtheGARCHmeasureofvolatility.
Thisresultappliedforboththeseven-country and 12-country panel-data
sets.
To helpdiscriminate betweentheBTU specification and thestandard
we
specification, investigated the extentto which the differing resultscould
beattributable tospecificationerrorsduetotheestimation procedures used.
To thisend,webeganbyusingthetwopanel-datasets,estimating boththe
BTU andstandardspecifications, applying first-generation RC technology.
Byso doing,theresultswerecorrected forpossiblefunctional-form mis-
specification,but not for specificationbiases due to omitted variables or
measurement errors.We foundone instanceofa negativeand significant
(at thetenpercentlevel)impactofvolatility on exports.
Wethenappliedsecond-generation RC technology. Thisprocedure cor-
rectsforspecification biases due to incorrectfunctional forms, omitted
variablesandmeasurement errors. Therewasno evidenceofa negative and
significant of
impact volatility on exports.
The following conclusionemergesfromour investigation. The finding
ofnegative andsignificanteffectofvolatilityon tradeappearsto arisefrom
omitted-variable biasesand/ormeasurement-error biases.Thisconclusion
followsfromboth(i) a comparisonoftheBTU specification and thestan-
dardspecification, whichomitsrealexportearningsofoil exporters, using
fixed-coefficientpanel-dataestimation methods,and (ii) fromtheresults
ofsecond-generation RC technology, whichtakesaccountofspecification
biases.
Theimplications ofourresults forfuture research includethefollowing.
to
First, investigate the robustness of ourresults, applicationofsecond-
the
generationtechnology modelsusedin theliterature,

to alternate including
would
gravityspecifications, appear to be a worthwhileline of inquiry.
Second,our studyfocusedon thelargerindustrial countries.
It mightbe
to investigate
interesting whether our resultshold-upto groupsofsmaller
industrial
countriesand/ordeveloping countries, as thelatter
particularly
economiesoftenlack well-developed financialmarketsthatcan provide
hedginginstruments againstexchange-raterisk.
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Some Further Evidence On Exchange-Rate Volatility and Exports (Baru)

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Some Further Evidence On Exchange-Rate Volatility and Exports (Baru)

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Some Further Evidence on Exchange-Rate Volatility and Exports

Abstract:The relationship betweenexchange-rate and aggregate

A large empiricalliteraturehas investigatedthe relationshipbetween

Remark:The viewsexpressedare thoseof the authorsand shouldnot be interpretedas

© 2008 KielInstitute DOT: 10.1007/sl0290-008-0141-4

techniques(fixedeffects, randomeffects, generalized methodofmoments

1 In some cases, recentauthorsfounda and positiverelationship between

effect ofvolatilityon tradeforthesevenindustrial countries consideredin

overviewof the theoretical betweenexchange-rate

Previousstudiesemployingpanel data have tendedto findevidenceof

The argument thatexchange-rate reducestradetypically

(i) Exporters maygainknowledgethroughtradethatmighthelp them

4 The Model and the Data

(withone exception)is ofthe

logХц = logaY+ a2logYífř+ a3logRPiit+ a4logOPt

whereXířis thevolumeofexportsofindustrial country ¿,Yířis realGDP

section,RC estimation doesnotadd an arbitrary errortermtoa mathemat-

11-country sum,e.g.,theindustrial-country trading-partner incomevari-

10 The countriescomprisethe IMF's oil-exporters

indicator ofthecountry considered to a weightedgeometric averageofthe

11 In his literature between

Ei,f= oio+ ofiE¿,t_i

hu = a + ßu]t_x+ Yht-i > (4b)

12 It followsfromthe of a time-varying coefficient

(ii) Fixedeffects. Supposethatcertain unobserved country- specificvariables

Eachofthefouraboveestimation techniques imposesassumptions that

(v) First-generation random-coefficient (RC) estimation. Effectively, first-

We estimate theTVC modelunderthefollowing RC assumption:For

The following setsofregressions wereestimated. First,thefourconstant-

17 Nevertheless, errorsdue to incorrect

of each country's relative-price variable,denotedas RP in equation(1),

18 The bias-free of thecoefficients RC modelsare esti-

Table 1: Panel Data EstimationofExportEquations:Seven Countries,BTU Model

Estimation Constant Industrial- Oil-exporter Real Exchange- Standard

Table1 and in subsequenttables,common-fixed-coefficients estimation is

as hypothesized. Third,comparingthe coefficients of thethreeexplana-

Table2: PanelData Estimation

Estimation Constant Industrial- Oil-exporter Real Exchange- Standard

negativeimpactofvolatility whenusinga specification that:(1) includes

Table 3: Panel Data EstimationofExportEquations:Seven Countriesy

Estimation Constant Industrial- Oil-exporter Real Exchange- Standard

At thispoint,a briefsummaryof theabovefindings maybe helpful

a GARCH measureof volatility. How do we discriminate amongthese

RC: BTU model

is obtainedusingthe standardmodel and the

Table6: PanelData Estimation

RC: BTU model

In Table6, thereis one measureof the coefficienton exchange-rate

generation RC estimation doesnotcorrect foromitted-variables biasand/or

Webeganbyestimating theBTU model,a specification appliedin the

generationtechnology modelsusedin theliterature,

Anderson, J.E., and E. vanWincoop(2003). Gravity withGravitas: A Solutionto

Dell'Ariccia,G. (1999). ExchangeRate Fluctuations and TradeFlows:Evidence

Swamy,P. A. V. В., and P. A. Tinsley(1980). LinearPrediction and Estimation

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