Estimating the Effect of Exchange Rate Changes on Total Exports

43 Pages Posted: 17 Jun 2019

See all articles by Thierry Mayer

Thierry Mayer

Sciences Po

Walter Steingress

Government of Canada - Bank of Canada

Date Written: June 4, 2019

Abstract

This paper shows that real effective exchange rate (REER) regressions, the standard approach for estimating the response of aggregate exports to exchange rate changes, imply biased estimates of the underlying elasticities. We provide a new aggregate regression specification that is consistent with bilateral trade flows micro-founded by the gravity equation. This theory-consistent aggregation leads to unbiased estimates when prices are set in an international currency as postulated by the dominant currency paradigm. We use Monte-Carlo simulations to compare elasticity estimates based on this new "ideal-REER" regression against typical regression specifications found in the REER literature. The results show that the biases are small (around 1 percent) for the exchange rate and large (around 10 percent) for the demand elasticity. We find empirical support for this prediction from annual trade flow data. The difference between elasticities estimated on the bilateral and the aggregate levels reduce significantly when applying an ideal-REER regression rather than a standard REER approach.

Keywords: trade elasticity, real effective exchange rate, gravity equation, dominant currency paradigm, aggregation bias

JEL Classification: F11, F12, F31, F32

Suggested Citation

Mayer, Thierry and Steingress, Walter, Estimating the Effect of Exchange Rate Changes on Total Exports (June 4, 2019). BIS Working Paper No. 786, Available at SSRN: https://ssrn.com/abstract=3400784

Thierry Mayer (Contact Author)

Sciences Po ( email )

28 Rue des Saint-Peres
Paris, Paris 75006
France

Walter Steingress

Government of Canada - Bank of Canada ( email )

234 Wellington Street
Ontario, Ottawa K1A 0G9
Canada

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