Do Multilateral Trade Linkages Explain Bilateral Real Exchange Rate Volatility?

Abstract

This paper investigates the impact of multilateral trade linkages on bilateral real exchange rate volatility by examining a particular channel —the extent of the effects of differences on import intensities (GDP’s share of imports of a given product and origin) between trade partners—of long-run real exchange rate volatility. I exploit a large panel of cross-country data over the years 1970–97 and construct a micro-founded index to capture this effect. In the estimations I address carefully endogeneity issues by testing not just exogeneity but also the presence of weak instruments. As robustness check and under the latter I estimate LIML and Fuller(1) regressions to ensure unbiased coefficients. Results strongly support the hypothesis that a pair of countries with a larger difference in the import intensities from the rest of the world faces a larger bilateral real exchange rate volatility. This result turns to be robust to the inclusion of bilateral trade a commonly argued moderator of volatility and other controls. These empirical findings are consistent with recent international trade models that highlight multi-country trade linkages.