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Journal of Macroeconomics 30 (2008) 238–259

www.elsevier.com/locate/jmacro

US trade and exchange rate volatility:

A real sectoral bilateral analysis
a,*
Joseph P. Byrne , Julia Darby b, Ronald MacDonald a

a
Department of Economics, University of Glasgow, Adam Smith Building, Bute Gardens,
Glasgow G12 8RT, United Kingdom
b
Department of Economics, University of Strathclyde, Sir William Duncan Building, Rottenrow,
Glasgow G4 0GE, United Kingdom

Received 30 November 2005; accepted 24 August 2006

Available online 29 November 2006

Abstract

In this paper we consider the impact of exchange rate volatility on the volume of bilateral US trade
(both exports and imports) using sectoral data. Amongst the novelties in our approach are the use of
sectoral industrial price indices, rather than an aggregate price index, and the construction of the sec-
toral groupings, which is based on economic and econometric criteria. We find that separating trade
into differentiated goods and homogeneous goods results in the most appropriate sectoral division,
and we also report evidence to suggest that exchange rate volatility has a robust and significantly neg-
ative effect across sectors, although it is strongest for exports of differentiated goods.
 2006 Elsevier Inc. All rights reserved.

JEL classification: F3

Keywords: Sectoral trade; Exchange rate volatility; Panel heterogeneity

1. Introduction

It is often argued, since at least Ethier (1973), that exchange rate volatility should have
a negative impact on international trade. This work is predicated on the assumption that

*
Corresponding author. Tel.: +44 141 330 4617; fax: +44 141 330 4940.
E-mail address: j.byrne@lbss.gla.ac.uk (J.P. Byrne).

0164-0704/$ - see front matter  2006 Elsevier Inc. All rights reserved.
doi:10.1016/j.jmacro.2006.08.002
 J.P. Byrne et al. / Journal of Macroeconomics 30 (2008) 238–259 239

firms are risk averse and exchange rate risk reduces the benefits of international trade. The
existence of financial markets allows agents to hedge exchange rate risk and this may
reduce or eliminate the potentially negative effect of exchange rate volatility on trade.
However, forward markets are not complete, or fully utilised (see Dominguez and Tesar,
2001) and indeed some theoretical papers have suggested that the basic effect of exchange
rate volatility on trade is unchanged even with complete capital markets (see Demers,
1991).
Rose (2000) notes that empirical research on the link between exchange rate volatility
and trade had essentially ceased towards the end of the 1990s. However, with analytical
developments and improvements in the quantity and quality of data, there has recently
been a re-examination of this issue (see, for example, Peridy, 2003; Broda and Romalis,
2004; Clark et al., 2004; Tenreyro, 2004; Klein and Shambaugh, 2004). Because there
may be differences in the impact of exchange rate volatility across sectors, recent studies
have often used sectoral trade data and sought economic justifications for differences
across industry. For example, Rauch (1999) develops a justification for different disaggre-
gate trade behaviour based on the business networks involved in international trade and
incomplete information.
In particular, Rauch (1999) emphasises the importance of search costs involved in
matching buyers and sellers for differentiated goods: trade of this kind is facilitated by
knowledge of particular markets or networks since the characteristics of some manufac-
tured products are not readily known (e.g. performance and reliability). Given these search
costs this also means that it is not easy for firms to switch foreign suppliers or find new
buyers in response to changes in the exchange rate. This will consequently affect profitabil-
ity, with negative effects in instances where individuals dislike increased risk. In contrast,
homogeneous, or intermediate, goods are typically traded on exchanges, product charac-
teristics do not vary between suppliers, can be substituted quickly and are therefore not
regarded as having search costs. There will be considerable indifference between homo-
geneous goods sourced from different suppliers.
However, existing studies of the effect of exchange rate volatility on detailed sectoral
and bilateral trade, use the CPI as the price deflator for trade. Such a deflator is likely
to be inappropriate at the individual sectoral level since it abstracts from the sharply dif-
fering sectoral price trends (e.g. in agriculture and in computers). In this paper we follow a
number of general international trade studies (see, for example, Head and Mayer, 2000;
Erkel-Rousse and Mirza, 2002; Saito, 2004) and use price series at the industrial level as
our deflator in our trade/exchange rate volatility relationships. Importantly, these general
studies do not condition on exchange rate volatility.
A further novelty in our work is that we propose using economic and econometric cri-
teria to underpin our sectoral disaggregation, while revisiting the effects of exchange rate
volatility on international trade. In particular, we implement Rauch’s approach to disag-
gregation in examining the impact of the second moment of the exchange rate on imports
and exports. Furthermore, in our econometric modelling of the trade relationships we con-
sider issues of measurement error associated with exchange rate volatility and also the end-
ogeneity of trade and volatility, as suggested by Hau (2002), Broda and Romalis (2004)
and Tenreyro (2004). Both of these econometric issues can be dealt with using instrumen-
tal variables and that is the approach we follow here. In our estimation we fully utilise a
large cross sectional data set by adopting a fixed-effects panel approach, which allows us to
test for cross sectional parameter heterogeneity.
240 J.P. Byrne et al. / Journal of Macroeconomics 30 (2008) 238–259

The remainder of the paper is laid out as follows. Section 2 provides a brief literature
review, Section 3 discusses our modelling methods, Section 4 sets out the data, Section 5
contains our results and Section 6 concludes.

2. Issues in the literature

In this section we present a brief overview of some related work. In particular, we overview
other studies which examine the trade–volatility relationship and then go on to review issues
relating to the appropriate price deflator and the measurement of exchange rate volatility.

2.1. Volatility and trade

One of the earliest empirical studies of the relationship between trade and exchange rate
volatility is that of Hooper and Kohlhagen (1978), who find limited evidence from the
impact of volatility on bilateral trade prices and no evidence on bilateral trade volumes.1
Bini-Smaghi (1991) argues that sectoral studies may have greater potential since they do
not constrain income and price elasticities to be equal across sectors as in aggregate stud-
ies. There have been a relatively small number of recent papers that empirically test the
impact of exchange rate volatility on trade using sectoral disaggregate data and these
are summarised in Table 1. As we shall see, the sectoral studies that have been conducted
have not been especially supportive of a negative relationship between trade and exchange
rate uncertainty and this may be attributable to the relatively small samples used and poor
price proxies employed. The only general conclusion that would seem to result from this
literature is that differences do exist across sectors.
Sectoral studies of trade and exchange rate volatility include Klein (1990), Belanger
et al. (1992) and de Vita and Abbott (2004). Klein (1990), for example, comprehensively
tests the impact of exchange rate uncertainty on US monthly bilateral sectoral exports
to six major industrial countries for nine industries. The value of exports is used since it
is suggested there are no sectoral bilateral export prices such that we could consequently
obtain sectoral bilateral trade volumes. Klein (1990) generally finds that uncertainty has a
positive effect on the value of trade. Belanger et al. (1992) considers the impact of nominal
exchange rate uncertainty on real sectoral US imports from Canada for five sectors, where
they deflate the value of imports by unit values. However, using unit value indexes may be
problematic since there is no account taken of the quality of exports. Their overall conclu-
sion is that exchange rate variability does not significantly depress the volume of trade.
The evidence for the UK is also not particularly indicative of a clear-cut significant
effect from exchange rate volatility to the volume of trade. For example, de Vita and
Abbott (2004) consider the impact of exchange rate volatility on UK aggregate exports
to individual EU countries and a multilateral study of five sectors’ exports to the other
EU countries. Making a distinction between short- and long-run uncertainty, they show
there is no evidence of an impact from short-run uncertainty, although there is evidence
of an impact from long-run volatility.2

1
For a survey of exchange rate volatility and trade more generally see McKenzie (1999).
2
It can be argued that short-run uncertainty is not important since trade can be hedged. This assumes firms
always make the most of available financial instruments. For papers which discuss evidence less than fully
consistent with this hypothesis see Wei (1999) and Dominguez and Tesar (2001).
Table 1
Relevant trade and exchange rate volatility studies
Authors Approach Data Conditioning variables Estimation Key results
Source Level of Countries Time (t) Deflator Demand Volatility
aggregation (j)
(i)
Klein (1990) Armington Bureau Sectoral 9 Bilateral 7 1978M2– None Industrial SD(D ln(P/ SURE 5/9 sectors affected

J.P. Byrne et al. / Journal of Macroeconomics 30 (2008) 238–259

of sectors country 1986M6 production SP*)t), positively by
Census Monthly t = 1, . . . , 12 volatility.
SITC Risk neutral
exporters
Belanger Armington Bureau Sectoral 5 Bilateral 1974Q1– Unit values Sectoral Forecast error IVE/ No significant effect
et al. of sectors US-Can 1987Q3 industrial of forward GIVE
(1992) Census Quarterly production market
Dell’Ariccia Gravity OECD Aggregate Bilateral 16 1975– Aggregate GDP SD(D ln St), IV/Pooled Controlling for
(1999) European 1994 unit values t = 1, . . . , 12 fixed- simultaneity,
Countries Forward error effects negative correlation
Max and min exists trade and
volatility
Rose (2000) Gravity UN Aggregate Bilateral 1970– US GDP GDP SD(D ln St), Fixed- Volatility + 1
186 1990 5 Deflator t = 1, . . . , 60 effects SD ) Trade falls
countries yearly 13%
Peridy (2003) Armington OECD Sectoral 20 Multilateral 1975– Supply GDP SD(D ln St), First Negative effect but
ITCS sectors G7. Each to 2000 variables t = 1, . . . , 12 difference not consistently
21 Annual and foreign GARCH OLS, significant. Different
countries production Rt = 1, . . . , 12 GMM effect across sectors
prices monthly
de Vita Armington UK Sectoral 4 Multilateral 1993M1– Multilateral Industrial SD(D ln St), ARDL Long-run volatility
and National sectors UK exports 2001M6 sectoral production t = 1, . . . , 12 has an effect on
Abbott Statistics to EU14 Monthly export price SD(lnSt), trade
(2004) t = 1, . . . , 12
Broda Armington/ Rauch Sectoral Bilateral 1970– Unit export GDP, GDP*, SD(D ln St), OLS/ If volatility
and Gravity (1999) Rauch (1999) exports 1997 prices per capita, t = 1, . . . , 60 St GMM doubles ) trade
Romalis SITC type: includes multi- Annual GDP · GDP* Hodrick– falls 2%: Increase in
(2004) Rev 2 differentiated country Prescott trade ) 12% fall
study volatility
(continued on next page)

241
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J.P. Byrne et al. / Journal of Macroeconomics 30 (2008) 238–259
Table 1 (continued)
Authors Approach Data Conditioning variables Estimation Key results
Source Level of Countries Time Deflator Demand Volatility
aggregation (j) (t)
(i)
Clark Gravity COMTRADE Sectoral Rauch Bilateral 1975– US CPI GDP SD(D ln(P/ Fixed and +1 SD ) Trade falls
et al. SITC Rev 1 (1999) type: 39 2000 5 SP*)t), time effects 7–9% but less impact
(2004) includes countries yearly t = 1, . . . , 12 with time effects
differentiated: 98
sectors
Tenreyro Gravity Feenstra et al. Aggregate Bilateral 1970– US CPI Gravity SD(D ln St), OLS and +1 SD ) falls 4–8%:
(2004) (1997) 104 1997 t = 1, . . . , 12 IV zero if IV
countries Annual ln St  ln St1
Saito Armington OECD ITCS Sectoral 10 sectors Bilateral 1970– OECD Industry No volatility FMOLS/ Bilateral trade data
(2004) SITC/ISIC 14 1997 ISDB value panel suggests lower
countries Annual industrial added elasticities than
unit labour minus multilateral data
costs exports
This Armington COMTRADE Sectoral 22 sectors Bilateral 1989– Industrial Industrial SD(D ln St), Fixed and Negative effects with
study HWWA ISIC 6 2001 VA deflator value t = 1, . . . , 12 time effects differentiated
Rev 3 countries Annual added imports and exports
 J.P. Byrne et al. / Journal of Macroeconomics 30 (2008) 238–259 243

Recent sectoral studies such as those of Peridy (2003), Broda and Romalis (2004) and
Clark et al. (2004) find little significant evidence of a relationship between measures of
exchange rate volatility and trade. Broda and Romalis (2004) conduct a bilateral sectoral
study and are particularly concerned with the extent of reverse causality (i.e. they do not
assume that exchange rate volatility is driven by exogenous shocks). They use data sepa-
rated into ‘‘differentiated’’ and ‘‘commodity’’ trade following Rauch (1999). Exchange rate
risk is assumed to have no affect on commodities – since these are obtained from organised
exchanges – but may have an affect on differentiated goods since they involve expensive
search costs. Trade stabilises volatility because the baskets of goods used to construct price
indices of proximate countries are similar.3 The large effect of exchange rate volatility on
trade is greatly reduced once the authors take account of reverse causality.
Clark et al. (2004), as part of their comprehensive study on trade and volatility, use dis-
aggregate data divided into homogeneous and differentiated goods. They adopt a gravity
framework and find evidence that there is a significant effect of exchange rate volatility on
differentiated goods: if volatility is increased by one standard deviation around its mean,
trade is reduced by 7–9%. Although this result is not robust to time effects, the authors
believe these may actually model the volatility effects themselves since they are time spe-
cific. Clark et al. use aggregate US CPI to obtain trade volumes, the merits of which we
discuss further below.
Peridy (2003) can be viewed as our point of departure since his is a sectoral multilateral
study of G7 exports. Emphasis is placed on avoiding sectoral and geographical aggrega-
tion bias (something explicitly tested for in our model). Peridy substitutes out domestic
sectoral prices using supply variables and his results depend on the industry covered
and the exporters location. Results suggest a consistently negative, if not significant, effect
from exchange rate volatility, although crude materials are more sensitive than manufac-
tured goods to the exchange rate. In a recommendation for future research, Peridy (2003)
suggests each bilateral relationship should be tested, an approach we adopt below.
Recently, Tenreyro (2004) adopts a similar approach to Rose (2000)4 by using gravity
equations for aggregate country data and considers the impact of uncertainty on trade.
She reports evidence of a negative effect from intra-year volatility on trade. However once
instrumental variables are used this effect all but disappears, which suggests there is a sub-
stantial endogeneity issue in the sample of countries that she uses.
In sum the extant studies on the exchange rate volatility trade relationship are not par-
ticularly supportive of a clear-cut relationship. This may be attributable to the relatively
small samples which have been used and the poor price proxies employed. By using better
measures of the price deflators, new sectoral definitions and larger samples we hope to pro-
vide sharper evidence on the trade exchange rate volatility link.

2.2. Bilateral sectoral import demand studies and sectoral prices

There have been a number of improvements made in the quality of data used in recent
trade studies based on the volume of real bilateral sectoral imports. A difficulty previous
studies have faced has been the absence of bilateral import prices. As mentioned above,

3
The authors invoke the empirical results from Hau (2002) who suggests that more open economies have faster
pass through from exchange rate changes to the domestic aggregate price level.
4
Rose (2000) finds a 13% reduction in trade from a one standard deviation increase in exchange rate volatility.
244 J.P. Byrne et al. / Journal of Macroeconomics 30 (2008) 238–259

researchers have used as a proxy the US CPI as a deflator for all trade, irrespective of
source or destination (as in Clark et al., 2004). But the use of such a proxy will result,
for example, in the same deflator being used for agricultural (homogeneous) and office
(differentiated) goods, despite the fact that these series are likely to have sharply differing
sectoral price trends. Studies that examine bilateral sectoral trade utilising sectoral prices
instead of country aggregates or the US CPI include Head and Mayer (2000), Erkel-
Rousse and Mirza (2002) and Saito (2004) who use the value added deflator, producer
prices and wage levels, respectively. Importantly, these studies do not condition on
exchange rate volatility. In this paper, we choose to use sectoral value added deflators
to obtain our measures of import volumes. We believe this is likely to be a superior mea-
sure because it should be a good proxy of the price of traded goods whilst taking account
of different sectoral trends. Also, to the extent that previous studies have not used relative
prices they may suffer from an omitted variables bias. We consider the impact of relative
prices in the analysis in this paper.

2.3. Measures of exchange rate uncertainty

There are a number of possible ways to measure exchange rate volatility, including,
moving average standard deviations, ARCH-based measures and higher frequency stan-
dard deviations. Baum et al.’s (2004) main contribution relates to how uncertainty is mod-
elled and they note that GARCH measures are model dependent and a moving window
conflates uncertainty over time periods. They consequently utilise information at a higher
frequency to construct a measure of uncertainty at a lower frequency. We use the standard
deviation of monthly exchange rate changes to obtain an annual uncertainty measure.
Consequently we are not conflating volatility across time periods and our measure is
not based on a particular model parameterisation.

3. Modelling issues

In this section we consider some aspects related to the modelling of the trade/exchange
rate uncertainty relationship. In particular, we briefly sketch the Armington approach to
modelling trade relationships, then we go on to outline our econometric methods and our
choice of sectoral disaggregation.

3.1. Theoretical model

We take an Armington (1969) approach to the estimation of trade relations, and we

estimate both price and output elasticities. The Armington model assumes separable con-
sumer utility for goods in an industry from consumption of other products. We assume a
constant elasticity of substitution (CES) utility function, where utility is derived from
domestic and foreign goods,
h=ðh1Þ
U ¼ ½cZ ðh1Þ=h þ ð1  cÞDðh1Þ=h  ; ð1Þ

where h is the constant elasticity of substitution between the domestic and traded goods, Z
is the trade volume which in our work is either exports, X, or imports, M, of imported
goods and D is the volume of domestic goods.
 J.P. Byrne et al. / Journal of Macroeconomics 30 (2008) 238–259 245

The first order condition from Eq. (1) is

  Z h
Z c P
¼ ; ð2Þ
D 1  c PD
where PZ and PD are trade and domestic prices, respectively. Re-writing (2) in logarithmic
form, we have
     Z
Z c P
ln ¼ h ln þ h ln D : ð3Þ
D 1c P
This relation has been empirically implemented for multilateral industry data by, inter
alia, Shiells et al. (1986) who suggest elasticities are unlikely to be equal across sectors.
This is also the approach of Saito (2004). A simplified form of the level relationship based
on bilateral industry data is as follows:
ln Z ijt ¼ aij0 þ b1;ij ln RP ijt þ b2;ij ln Di:t þ eijt ; ð4Þ
where Zijt denotes trade from country j for industry i, Di.t is domestic output for industry i
and ln RP :j ¼ ln P Z:j  ln P D:: .
We also incorporate an exchange rate volatility term (VOL.j), based on risk aversion
arguments, into our preferred specification. Ethier (1973) emphasises that the exchange
rate is the main source of profit risk for a risk averse firm. Demers (1991) suggests that
even with risk neutral firms a negative association between trade and volatility can be gen-
erated. For example, if trade is dependent upon irreversible investment increased uncer-
tainty will lead to a delay in increasing output capacity and hence trade.5 Consequently
our static relationship becomes
ln Z ijt ¼ aij0 þ b1;ij ln RP ijt þ b2;ij ln Di:t þ b3;ij VOL:jt þ eijt ; ð5Þ
where b1 is the price elasticity of substitution. Eq. (5) can be estimated within a panel
framework, which facilitates testing the equivalence of coefficients across industries:
bk,ij = bk,ij "i. Indeed, in a panel context we can also combine trade from a number of
countries and all industries into our basic specification: bk,ij = bk,ij "i, j. Additionally,
we divide goods into differentiated/homogeneous products and we discuss this below
and as noted previously we also compare the effect of exchange rate volatility on imports
and exports. Since exports may be considered closer to the producing firm, exchange rate
volatility may have a different effect.

3.2. Econometric methods

In this paper we use a fixed-effects estimator to test our major hypothesis. As suggested
above, we impose equivalent coefficients on the levels of the variables. Levels relationships
are more likely to be homogeneous across cross sections where there are strong theoretical
priors. Within the fixed-effects framework it is possible to test the equivalence of cross sec-
tional coefficients using a Hausman type test. If the estimated coefficients in Eq. (5) are not
equivalent, but are mistakenly restricted to be so, this may result in biased estimated
coefficients.6

5
We also consider the impact of oil price volatility.
6
See Pesaran and Smith (1995) for a discussion on the effect of heterogeneity in panel estimation.
246 J.P. Byrne et al. / Journal of Macroeconomics 30 (2008) 238–259

Pagan (1984) argues that instrumental variables are a necessary means of dealing with
generated regressors when modelling risk and uncertainty. The trade and uncertainty lit-
erature has also found IV useful since there is some concern with, in particular, Hau’s
(2002) finding of openness reducing exchange rate volatility. Rose (2000) finds evidence
that monetary arrangements can have an important bearing on trade equations estimated
using panel methods. However, since the European countries considered in this paper did
not participate in any formal exchange rate arrangements with the US during our sample
period (1989–2001) we do not regard this as an issue here. Clark et al. also consider two
methods of IV, with one based on the Frankel and Wei (1993) measure of long-run vola-
tility of relative money supplies. We are not convinced economic fundamentals can instru-
ment exchange rate changes at a one month horizon, and in any case doing so would
extract much of the noise in foreign exchange markets, which can be costly to a firm
engaged in trade. This issue seems to be related to permanent and temporary volatility.
For example, Savvides (1992) suggests unanticipated volatility has a stronger negative
effect on trade flows than does anticipated volatility. By running a regression of volatility
on openness, terms of trade and productivity shocks, Savvides extracts the unanticipated
or temporary component. Bini-Smaghi (1991) also highlights how unexpected volatility
seems to have a greater effect on trade. Therefore, papers which utilise an IV estimator
and find no effect on trade may potentially be considering the impact of the expected or
permanent component of uncertainty on trade.
Consequently, we adopt fixed-effects estimation and allow for both cross sectional and
period effects. We adopt a method of instrumental variable estimation, by taking the fitted
values from an AR(n) regression of exchange rate volatility and incorporate the fitted val-
ues into our basic trade specification (Eq. (5)).

3.3. Sectoral heterogeneity

As mentioned above, Bini-Smaghi (1991) suggests that there may be different import
demand and price elasticities across countries/sectors and this may be a reason why aggre-
gate studies have found little evidence of the affect of exchange rate volatility on trade.
Peridy (2003), for example, finds evidence of a different effect from exchange rate volatility
across sectors. Rauch (1999) provides a theoretical justification for differences based on
differentiated and homogeneous goods, due to supply networks. We suggest final durable,
non-durable goods and investment goods are a good proxy for differentiated goods and we
regard intermediate goods as a good proxy for homogeneous goods. Our differentiation is
based on those of the UK National Statistics agency.7

4. Data

The data used in this study are from three main sources. The value of US imports, in
US Dollars, is originally from the UN database COMTRADE. This is converted from
product categories (SITC) to industrial sectors (ISIC) by HWWA. Additionally, we utilise
exports from our sample of European countries to the US. We also use the Groningen,

7
Table A1 in Appendix provides further details on the sectoral disaggregation. We further tested for other
potential groupings of industrial sectors, based on skills and technology. However, these approaches were not
fruitful.
 J.P. Byrne et al. / Journal of Macroeconomics 30 (2008) 238–259 247

Growth and Development Centre database (also adopting a ISIC classification) to obtain
sectoral value added and value added deflators.8 The data appendix provides more details.
We utilise annual data over the period 1989–2001 (T = 13), for imports and 1989–2000
(T = 12), for exports from the UK, Germany, France, Italy, Netherlands and Spain,
and the span of countries is based on data availability. At its maximum we have a cross
section of 22 industries and 6 countries, (N = 132). Our study is slightly more focused than
studies which cover a much greater span of countries.9 This is out of necessity given the
detailed disaggregate data series that we are considering here. Also the use of disaggregate
deflators encourages us to adopt the Armington approach, in contrast to other strands of
the literature which abstracts from different deflators and adopts a Gravity approach.
We obtain the volume of trade by deflating the value of imports, or exports, for our
sectors by our sectoral price proxy, the value added deflator. Our annual measure of
exchange rate volatility (VOL) is the standard deviation of the log first difference of bilat-
eral US Dollar monthly exchange rate (from IMF, International Financial Statistics). We
also consider the impact of the annual real oil price volatility (VOIL) based on the first
difference of monthly West Texas Intermediate deflated by the US consumer price deflator.
Table 2 provides summary statistics of the data. Most US imports, based on our classifi-
cation, are in differentiated goods (i.e. around three quarters). In terms of exchange rate
volatility, the continental European countries exhibit marginally greater bilateral Dollar
volatility than the UK in our sample period. We also incorporate an exchange rate mis-
alignment term, which may be important in this context, and we capture this in terms
of deviations from purchasing power parity (PPP). Clearly, given the evident slow mean
reversion speeds of real exchange rates, trying to capture exchange rate misalignment
using PPP is likely to be contentious. However, given that there is no universal agreement
in the profession about the most appropriate way of defining an equilibrium exchange
rate, and given our main focus is on exchange rate volatility, we believe our misalignment
measure is not unreasonable.10

5. Results

Our estimation approach is based on the following determinants of the volume of trade:
ln Z ijt ¼ f ðln Y i:t ; RP ijt ; VOL:jt ; MPPP :jt ; VOIL::t Þ; ð6Þ

where Zijt is the value of US trade for industry i (either imports, M, or exports, X) from
country j, deflated by the sectoral value added deflator Pijt, Yi.t is the sectoral value added
in US industry i, RPijt is the relative price between country j and the US for industry i,
VOL.jt is bilateral US Dollar exchange rate volatility against country j, MPPP.jt is the mis-
alignment term based on deviations from purchasing power parity of the Dollar against
currency j, and VOIL..t is the volatility of the oil price. Estimation is based on static
fixed-effects. The results presented here are derived using a simple instrumental variables
method where we take the fitted values from an AR(n) of exchange rate volatility itself

8
US imports are mainly (around 88%) priced in US Dollars, Tavlas (1997). Price changes from suppliers will
have an immediate impact on import prices.
9
For example, Rose (2000) considers 186 diverse countries at the aggregate level.
10
Indeed there may be greater evidence of purchasing power parity at the disaggregate level, see Crucini and
Shintani (2004) and Imbs et al. (2005).
248 J.P. Byrne et al. / Journal of Macroeconomics 30 (2008) 238–259

Table 2
Data summary
UK Germany France Italy Netherlands Spain Total
US imports US$Bn 21.6 35.2 16.1 14.1 8.2 3.7 98.9
(1995)
Differentiated 16.0 27.2 11.1 9.8 6.0 1.8 73%
(1995)
Homogeneous 5.6 8.0 5.0 4.3 2.2 1.9 27%
(1995)
Mean 2.20 2.49 2.44 2.48 2.52 2.52
VOL(min, max) (1.16, 4.61) (1.61, 3.85) (1.15, 3.74) (0.61, 4.58) (1.38, 3.85) (1.26, 3.97)
Mean 6.99
VOIL(min, max) (4.21, 15.79)
Notes: See Table A1 for further details of industrial groupings. VOL is exchange rate volatility against US Dollar.
VOIL is oil price volatility.

(n is determined by an Information Criteria). We believe that the instruments will primar-

ily control for measurement error. Since the US did not have formal or informal exchange
rate arrangements with European countries in the 1990s, there is unlikely to be the kind of
endogeneity issues encountered by Tenreyro (2004).11 Our sectoral disaggregations, are
based on networks (when we separate industries into differentiated or homogeneous
groupings) and we use a Hausman test suggested by Pesaran et al. (1996) to confirm
whether our choice of pooled sectors is appropriate.

5.1. Total goods trade

Our first set of results for the impact of exchange rate volatility on sectoral trade are
presented in Table 3, where we consider the impact on all industries combined in a single
panel. Note, first, the demand and relative price terms are significant and reasonably signed.
They are approximately equivalent for both imports and export groupings. Exchange rate
volatility proves to be strongly significant and has a negative effect on both imports and
exports, although the impact is almost a third larger in estimated sign and marginally more
significant in the export equations. The estimated coefficient on the exchange rate misalign-
ment term is positively signed, as expected, for both imports and exports. A depreciation of
the exporting country’s currency greater than that suggested by PPP will have a positive
and significant effect on trade. There does not appear to be an important role for oil price
volatility in this specification. A Hausman test, based on equivalence of the fixed-effects
and a random coefficients estimator, provides evidence that we cannot pool all cross sections
at once, which is suggestive that we should be working with disaggregate sectors.
Although our estimated specification is written for bilateral trade, there are likely to be
important third country effects which will impact on our bilateral trade levels. For exam-
ple, Clark et al. (2004) emphasise that an analysis of the effects of volatility on trade using
fixed-effects estimation does not fully take account of the problem of ‘‘multilateral resis-
tance’’ as introduced by Anderson and van Wincoop (2003). In particular, fixed-effects will
only account for third country effects to the extent they are constant, but they will not

11
For example Tenreyro (2004) does find that instrumental variables can be influential, but she has a much
larger number of countries in her study of aggregate data, whilst we approach the question using sectoral data.
Table 3

J.P. Byrne et al. / Journal of Macroeconomics 30 (2008) 238–259

Trade of all industries: fixed-effects
Imports Exports
(i) (ii) (iii) (i) (ii) (iii)
Value added 1.065 (45.996) 0.999 (39.835) 1.064 (45.940) 1.057 (37.547) 0.988 (32.675) 1.058 (37.560)
(Yi.t)
Relative prices 1.436 (29.227) 1.162 (18.042) 1.431 (28.986) 1.327 (22.481) 1.064 (14.460) 1.332 (22.484)
(RPijt)
Ex. rate vol. 0.068 (5.207) 0.070 (5.403) 0.070 (5.268) 0.087 (6.140) 0.085 (6.035) 0.085 (5.829)
(VOL.jt)
Misalignment 0.626 (6.461) 0.705 (5.870)
(MPPP.jt)
Oil price vol. 0.003 (0.824) 0.004 (1.009)
(VOIL..t)
Hausman 304.95 [0.000] NA 202.18 [0.000] 36.66 [0.000] 65.64 [0.000] 518.56 [0.000]
statistic
[homogeneity]
Notes: Results are based on fixed-effects estimation (t-statistics in parentheses, significant at 5% level in bold). Hausman test has a joint null of cross sectional
parameter homogeneity and is based on equivalence of coefficients of fixed-effects estimation and a random coefficients model [p-values in squared brackets]. All
industrial sectors pooled (22 sectors) for six countries. Sectors included: Fish, Food, Textiles, Cloth, Leather, Wood, Pulp, Print and Publishing, Mineral Oil,
Chemicals, Rubber, Non-Metallic Mineral Products, Basic Metals, Fabricated Metal, Mechanical Engineering, Office Machinery, Electrical Machinery, Radio and
TV, Instruments, Motor Vehicles, Ships and Boats, Air and Space.

249
250 J.P. Byrne et al. / Journal of Macroeconomics 30 (2008) 238–259

account for variation in these effects. Since for example, tariffs may change between the
countries under examination, and for countries not included in our study, this could con-
sequently influence the level of bilateral trade under study. Clark et al. (2004) suggest that
trade equations can be made robust to such ‘‘multilateral resistance’’ by incorporating
time effects into the analysis. When the authors do this they generally find less, or no, evi-
dence of an effect from exchange rate volatility on trade.12 We consequently cross section-
ally demean our data to take account of time effects. Additionally, such period
idiosyncrasies could be important in representing global business cycles and shocks. Tak-
ing account of time effects is also important for econometric reasons, since our estimation
approach assumes the residuals are cross sectionally independent and it is not possible to
implement a SUR analysis given the dimensions of our panel (N > T).
Table 4 presents the results for all industries taking account of cross section and period
effects. Both the size of output and relative price elasticities are reduced slightly in both
import and export equations. Interestingly, the effect of volatility on import trade disap-
pears (although it remains negative in sign and the t-statistic is around one). For exports
there is an effect from exchange rate volatility which is approximately the same size as
before and is still significant at the 1% level. This suggests that because exports are more
proximate to the decisions of the firm, they may be more responsive to volatility. Imports
on the other hand include cost, insurance and freight which may be unresponsive to vol-
atility. The misalignment term is not significant with the demeaned data. There is some
evidence from a Hausman test that we can pool estimated coefficients across cross sections.
However, the Hausman test for the most interesting and relevant specification (i) for
exports, indicates that we cannot pool all 22 industries together, which suggests that we
should pursue a further disaggregation of our cross sections.13

5.2. Differentiated goods trade

Although we assume that there are equivalent coefficients across cross sections, this is
not always born out by the evidence. Rauch (1999) has often been invoked to suggest that
exchange rate volatility (which is one particular type of transaction cost for trade) may
have a larger effect on differentiated goods trade. Table 5 reports results for differentiated
goods trade and suggests that output and relative prices are again important for both
imports and exports. The size of the estimated relative price coefficient for differentiated
goods trade is slightly less than for total trade, which would lead us to believe that differ-
entiated goods trade is less sensitive to relative prices, consistent with the search costs
involved in differentiated goods trade, as emphasised by Rauch (1999). There is an impor-
tant role for the misalignment terms in these specifications but not for oil price volatility.
However, results from the Hausman test do not suggest that we can pool these sectors.

12
Clark et al. (2004) acknowledge that including cross section and time dummies may overcorrect for the
problem of ‘‘multilateral resistance’’ and that the forces underlying bilateral exchange rate volatility are time and
cross section specific. Clark et al. (2004) go somewhat further and include time-varying fixed-effects. How
appropriate such an approach is may be open to question since it will be intensive in terms of degrees of freedom,
could potentially increase the size of estimated coefficient standard errors and counteract many of the efficiency
benefits of panel estimation.
13
We note that in panels there may be less of a problem with spurious regression issues due to cross sectional
averaging using fixed-effects, see Phillips and Moon (1999). Preliminary evidence based on Pedroni’s (1999) panel
cointegration tests were consistent with this perspective.
 J.P. Byrne et al. / Journal of Macroeconomics 30 (2008) 238–259
Table 4
Trade of all industries: fixed and time effects
Imports Exports
(i) (ii) (iii) (i) (ii) (iii)
Value added 0.958 (38.712) 0.962 (38.566) 0.958 (38.700) 0.932 (31.330) 0.931 (31.057) 0.932 (31.319)
(Yi.t)
Relative prices 1.125 (18.683) 1.150 (18.090) 1.125 (18.677) 1.050 (15.381) 1.046 (14.496) 1.050 (15.375)
(RPijt)
Ex. rate vol. 0.035 (1.252) 0.026 (0.920) 0.035 (1.252) 0.085 (2.743) 0.086 (2.736) 0.085 (2.742)
(VOL.jt)
Misalignment 0.216 (1.214) 0.040 (0.200)
(MPPP.jt)
Oil price vol. 0.000 (0.000) 0.000 (0.000)
(VOIL..t)
Hausman statistic 2.28 [0.516] 5.13 [0.274] 1.32 [0.859] 8.79 [0.032] 3.18 [0.528] 1.18 [0.881]
[homogeneity]
Notes: Based on fixed-effects estimation using cross sectionally demeaned data (t-statistics in parentheses, significant at 5% level in bold). Hausman test has a joint
null of cross sectional parameter homogeneity and is based on equivalence of coefficients of fixed-effects estimation and a random coefficients model [p-values in
squared brackets]. For sectors included see Table 3.

251
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J.P. Byrne et al. / Journal of Macroeconomics 30 (2008) 238–259
Table 5
Differentiated goods trade: fixed-effects
Imports Exports
(i) (ii) (iii) (i) (ii) (iii)
Value added 1.076 (39.424) 0.985 (32.480) 1.075 (39.393) 1.062 (33.517) 1.000 (28.597) 1.062 (33.508)
(Yi.t)
Relative prices 1.359 (19.978) 0.973 (10.785) 1.347 (19.678) 1.280 (16.301) 1.025 (10.258) 1.285 (16.263)
(RPijt)
Ex. rate vol. 0.083 (4.397) 0.086 (4.616) 0.089 (4.601) 0.098 (4.992) 0.095 (4.924) 0.096 (4.791)
(VOL.jt)
Misalignment 0.909 (6.360) 0.690 (4.079)
(MPPP.jt)
Oil price vol. 0.007 (1.471) 0.003 (0.540)
(VOIL..t)
Hausman 163.49 [0.000] NA 10.60 [0.032] 19.20 [0.000] 41.95 [0.000] 44.33 [0.000]
statistic
[homogeneity]
Notes: Based on fixed-effects estimation (t-statistics in parentheses, significant at 5% level in bold). Hausman test statistic has a joint null of cross sectional parameter
homogeneity and is based on equivalence of coefficients of fixed-effects estimation and a random coefficients model [p-values in squared brackets]. Differentiated
goods trade (14 sectors) is Durable, Non-Durable and Investment goods and includes the following sectors: Fabricated Metal, Mechanical Engineering, Office
Machinery, Electrical Machinery, Radio and TV, Instruments, Motor Vehicles, Ships and Boats, Air and Space, Fish, Food, Textiles, Cloth, Print and Publishing.
 J.P. Byrne et al. / Journal of Macroeconomics 30 (2008) 238–259
Table 6
Differentiated goods trade: fixed and time effects
Imports Exports
(i) (ii) (iii) (i) (ii) (iii)
Value added 0.939 (31.416) 0.939 (31.006) 0.939 (31.403) 0.945 (27.329) 0.940 (26.870) 0.945 (27.314)
(Yi.t)
Relative prices 0.929 (11.014) 0.923 (10.318) 0.929 (11.009) 1.009 (10.819) 0.974 (9.836) 1.009 (10.813)
(RPijt)
Ex. rate vol. 0.032 (0.806) 0.034 (0.831) 0.032 (0.821) 0.111 (2.588) 0.118 (2.728) 0.111 (2.586)
(VOL.jt)
Misalignment 0.052 (0.204) 0.292 (1.064)
(MPPP.jt)
Oil price vol. 0.002 (0.350) 0.000 (0.000)
(VOIL..t)
Hausman statistic 0.66 [0.883] 2.92 [0.571] NA 0.72 [0.868] 3.71 [0.446] 0.22 [0.994]
[homogeneity]
Notes: Based on fixed-effects estimation using cross sectionally demeaned data (t-statistics in parentheses, significant at 5% level in bold). Hausman test has a joint
null of cross sectional parameter homogeneity and based on equivalence of coefficients of fixed-effects estimation and a random coefficients model [p-values in squared
brackets]. For further details of sectors included, see Table 5.

253
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J.P. Byrne et al. / Journal of Macroeconomics 30 (2008) 238–259
Table 7
Random-effects (two way) estimation
Imports Exports
Total Different. Homogen. Total Different. Homogen.
Value added 0.974 (39.847) 0.977 (33.180) 0.399 (5.235) 0.946 (32.471) 0.981 (29.036) 0.366 (3.516)
(Yi.t)
Relative prices 1.173 (18.541) 1.002 (11.323) 1.457 (21.190) 1.076 (15.026) 1.061 (10.862) 1.079 (11.221)
(RPijt)
Ex. rate vol. 0.028 (0.988) 0.036 (0.899) 0.012 (0.410) 0.086 (2.765) 0.118 (2.736) 0.037 (0.945)
(VOL.jt)
Misalignment 0.268 (1.533) 0.126 (0.505) 0.487 (2.793) 0.045 (0.233) 0.083 (0.311) 0.253 (1.031)
(MPPP.jt)
Constant 2.130 (6.445) 2.052 (5.060) 8.222 (9.878) 2.558 (6.857) 2.254 (5.114) 8.530 (7.597)
Hausman 8.39 [0.078] 30.01 [0.000] 1.89 [0.756] 8.76 [0.068] 22.63 [0.000] 1.13 [0.89]
statistic [fixed
vs. random-
effects]
Notes: Based on random-effects estimation, (t-statistics in parentheses, significant at 5% level in bold). Hausman test is a test of equivalence of fixed-effects and
random-effects [p-values in squared brackets]. Rejection of the null suggests fixed-effects is the appropriate method. All industrial sectors pooled (22 sectors) for six
countries. For further details of sectors see Table A1.
 J.P. Byrne et al. / Journal of Macroeconomics 30 (2008) 238–259 255

We also go on to consider the importance of time effects by cross sectionally demeaning

the data. From Table 6, we do not find an important role for exchange rate volatility on
imports. We find evidence of volatility effecting exports (replicating the results for total
export trade although the size of the coefficient is slightly larger). The effect of the mis-
alignment term again becomes insignificant in the presence of time effects irrespective of
whether we consider imports or exports. Of course a general deviation of the dollar from
equilibrium may be being modelled by the time effects. There is no role for oil price vol-
atility, suggesting our results are insensitive to including this factor. The Hausman test
(based on equivalence of fixed-effects and a random coefficients model) indicates that
we can pool the cross sections in this situation which suggests we now have an appropriate
level of disaggregation.

5.3. Random-effects estimation

As a robustness check we consider (two way) random-effects estimation. Random-

effects estimation, unlike fixed-effects, assumes regressors and unobserved factors are
uncorrelated. If fixed-effects and random-effects estimation is different, this suggests there
is a correlation. A Hausman approach, different from the earlier test of parameter heter-
ogeneity, can be used to examine the equivalence of fixed and random-effects estimation
and hence whether unobserved factors are correlated with the regressors, see Hsiao
(2003). This can shed light on the suggestion by Clark et al. (2004) that volatility effects
disappear in the presence of time dummies, since they model volatility’s period specific
nature.
In Table 7 using random-effects estimation we find that differentiated and total exports
trade remains negatively affected by exchange rate volatility.14 However, the Hausman test
for differentiated goods trade rejects random-effects estimation, supporting our earlier use
of fixed-effects. Additionally this provides evidence supporting Clark et al.’s (2004) point
that unobserved factors may be correlated with volatility and partly explains why they do
not find an impact on trade. Homogeneous goods exports are unresponsive to exchange
rate volatility using random-effects estimation, consistent with Rauch’s (1999) suggestion,
and emphasising the importance of finding appropriate groupings.

6. Conclusion

In this paper we have considered the impact of exchange rate uncertainty on sectoral
bilateral imports and exports to the US from a sample of six European countries. The
main novelties over other work in this area, for example Clark et al. (2004), lies in our
use of disaggregate price data as our trade deflator, rather than the US consumer price
index, and our construction of new disaggregate sectors to examine the importance of
exchange rate uncertainty. The use of a deflator such as the US CPI may result in the
imposition of inappropriate constraints, which affect subsequent results and may explain
why exchange rate volatility often appears as an insignificant explanatory variable in trade

14
The estimated coefficient on the impact of exchange rate volatility on homogeneous goods exports is more
than two standard errors greater than the estimated coefficient on differentiated exports, which indicates that
these two groupings are significantly different. This is consistent with the evidence from the Hausman Poolability
tests which indicated that we have appropriately grouped sectors.
256 J.P. Byrne et al. / Journal of Macroeconomics 30 (2008) 238–259

equations. Also our use of detailed sectoral deflators emphasises the pertinence of an
Armington specification. Our construction of the disaggregate sectors is based upon eco-
nomic and econometric considerations and we find Rauch’s (1999) discussion on the dif-
ferent effect of networks on trade pertinent here. To recap, for goods which trade only
where there are costly networks in place, any factor which reduces the revenue of such
trade will have a direct bearing on the firm’s profitability. For goods sold on organised
exchanges it is much easier to find alternative buyers when market conditions change
and where exchange rates move against a firm’s decision to engage in international trade,
it should be possible to switch markets. In the latter situation exchange rate volatility
should not adversely affect trade.
Amongst our findings is the result that pooling all industries together provides us with
evidence of a negative effect on trade from exchange rate volatility. But using econometric
criteria in particular we find evidence that this effect may be different across industries, as
suggested most recently by the empirical study of Peridy (2003), although he abstracts from
relative price effects. We also find that output and relative price coefficients are different on
a disaggregated basis. Moreover, the effect of exchange rate uncertainty is negative and sig-
nificant for differentiated goods, which is the great majority of trade, and insignificant for
homogeneous goods, supporting the arguments of Rauch (1999). This would seem to sug-
gest that sectoral differences do exist in explaining the different impact of volatility on trade
and may be based on the characteristics of the markets in which they trade. We believe this
is an important finding and may be the key to understanding why so many studies have not
found a clear-cut empirical relationship between exchange rate volatility and trade when
using aggregate trade data. It also suggests that a greater degree of disaggregation, at the
industry, product or firm level, may provide further worthwhile results.

Data Appendix

Trade data

The Hamburg Institute of International Economics (HWWA) World Matrix of Sectoral

Economic Data (http://www.hwwa.de/wmatrix) provides bilateral trade data for OECD
countries on a sectoral basis over the period 1989–2001. Imports and exports are broken
down by commodities and by partner countries. Values are expressed in thousands of Uni-
ted States Dollars and relate to declared transaction values (imports c.i.f., exports f.o.b.).
The exchange rates from national currencies into United States Dollars are taken from
United Nations’ Statistics Division, UNSD. The core data in the World Matrix come from
the OECD’s International Trade by Commodities Statistics (ITCS) and the UN’s Commod-
ity Trade Statistics (COMTRADE). The disaggregation by industries and product groups
follows the Standard International Trade Classification (SITC).
A major advantage in taking the data from the World Matrix is that HWWA have
applied the necessary conversion key to produce data by International Standard Industrial
Classification (ISIC). This makes it possible to relate foreign and domestic data on a com-
mon statistical basis (domestic data, including sector/industry specific value added and
value added deflators are conventionally provided by ISIC).
The conversion key is taken from Eurostat’s classification server. World Matrix data
has been aggregated from the 312 product groups at 3 digit SITC Rev.3, to the 27 indus-
tries at ISIC Rev.3 2 digit level (and partly 3 and 4 digit level). [The full correspondence
 J.P. Byrne et al. / Journal of Macroeconomics 30 (2008) 238–259 257

Table A1
Industrial classifications and groupings
Industry ISIC Differentiated Homogeneous/intermediate
D&I ND
Fishing I05 ·
Food, drink and tobacco I15–16 ·
Textiles I17 ·
Clothing I18 ·
Leather and footwear I19 ·
Wood and products of wood and cork I20 ·
Pulp, paper and paper products I21 ·
Printing and publishing I22 ·
Mineral oil refining, coke and nuclear fuel I23 ·
Chemicals I24 ·
Rubber and plastics I25 ·
Non-metallic mineral products I26 ·
Basic metals I27 ·
Fabricated metal products I28 ·
Mechanical engineering I29 ·
Office machinery I30 ·
Electrical machinery I31 ·
Radio, TV and communication I32 ·
Instruments I33 ·
Motor vehicles I34 ·
Building and repairing of ships and boats I351 ·
Aircraft and spacecraft I353 ·
Notes: Differentiated goods include Durable and Investment (D&I) and Non-Durable (ND) goods. Differentiated
and Homogeneous good classifications are based on National Statistics (2004).

table, 5 digit SITC Rev.3 (= 3069 product groups) to 4 digit ISIC Rev.3 (= 127 industries)
is available at Eurostat’s classification server at http://europa.eu.int/comm/eurostat/
ramon/. We used a version of this and aggregated up to a 3 digit SITC and 2 digit ISIC
converter.]

Value added and value added deflators

Sector specific deflators available from the Groningen Growth and Development Cen-
tre 60-Industry Database at http://www.ggdc.net. This provides internationally compara-
ble data for OECD countries based on the 2-digit ISIC classification. Both value added
and value added deflators are available for the period 1979–2001.

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