Our objective in this chapter is to evaluate the conjecture that an increase in exchange rate volatility leads to a decrease in the volume of international trade. Most empirical tests do not find a strong negative relation between exchange rate volatility and the volume of international trade. Our theoretical analysis provides a potential explanation for these results. We also address two weaknesses in the existing literature on exchange rate volatility and international trade, as pointed out by Perée and Steinherr (1989): the existing theoretical models are partial equilibrium in nature, and in the empirical work a linear relation between trade and exchange rate risk is postulated while the true relation might be nonlinear. Specifically, our work determines a nonlinear relation between exchange rate volatility and the volume of international trade and does this in the context of a general-equilibrium model.

The model that we use to illustrate our arguments is similar to that described in Chapter 3. In contrast to existing partial-equilibrium work studying the relation between international trade and exchange rate volatility, in our model the exchange rate and the prices of financial securities are determined endogenously. Our major result is that in this general-equilibrium setting an increase in exchange rate volatility may be associated with either an increase or a decrease in the volume of international trade, depending on the source of the change in volatility. Because even in our simple model there exists no unambiguous relation between exchange rate volatility and trade, it is clear that, in more complicated models (and in the real world), there need not be a clear relation either.