Reconnecting Exchange Rates with Gravitas

Abstract

We uncover a strong, temporal connection between trade and the exchange rate factor structure by instrumenting trade with trade deals. A typical agreement raises bilateral trade by 50 percent over five years which, in turn, reduces the systematic risk of the pair's exchange rate by a third of its standard deviation across countries. Our structurally estimated gravity model endogenizes the factor structure and shows that deals excel at pulling peripheral countries into the trade network's core, mitigating their currencies' systematic risk. Overall, our paper underscores that trade deals are not just about trade.

Keywords: exchange rates, common factor structure, trade network, trade agreements

JEL Classification: F11, F31, G15