Welfare Costs of Bilateral Currency Crises: The Role of International Trade
One sentence summary: A single currency crisis can result in welfare reductions through international trade corresponding up to 41% of the costs of autarky.
The corresponding paper by Hakan Yilmazkuday has been accepted for publication at International Finance.
Free access to the read-only version is available here.
The working paper version is available here.
Abstract
This paper shows that bilateral currency crises reduce bilateral trade up to 50% after controlling for the depreciation rate. Using a trade model, these reductions are connected to the welfare costs of currency crises. The results show that a single currency crisis can result in welfare reductions through changes in international trade corresponding to more than 10% (and up to 41%) of the costs of autarky for 23 different currency crisis episodes between 1960 and 2014. These welfare costs are also shown to be greater than the welfare gains from having free trade agreements and using common currencies for 25 different currency crisis episodes.
Non-technical Summary
The negative effects of having a currency crisis at the country level are well known. These country-level currency crises are mostly identified by using the depreciation of the nominal exchange rate of a country with respect to a vehicle currency such as the U.S. dollar. However, international trade patterns are determined over bilateral exchange rates, since both exporters and importers solve their optimization problems based on their home currencies due to their costs and/or income being subject to these currencies. Therefore, the negative effects of currency crises on international trade can be at the bilateral level, especially when bilateral currency transactions are interrupted due to a crisis.
This paper investigates the possibility that bilateral currency crises (defined over bilateral nominal exchange rates) can affect bilateral imports. This is achieved by using the implications of a trade model, where bilateral currency crises are accepted as additional trade costs due to potential increases in transaction costs. Accordingly, bilateral imports are shown to depend on bilateral currency crises after controlling for the depreciation rate of the importer country's currency with respect to the exporter country's currency. This implication is tested empirically by using bilateral trade data from 66 countries covering the annual period between 1960-2014. The empirical results suggest that having a bilateral currency crisis can reduce international trade up to 50%, depending on the severity of the crisis.
These negative effects of bilateral currency crises are further connected to the corresponding welfare costs by using the implications of the trade model. It is shown that these welfare costs can be measured as the weighted average of the negative effects of bilateral currency crises on international trade, where weights are bilateral import shares. The corresponding empirical results suggest that the welfare costs of a single bilateral currency crisis are up to 2.5% (for Costa Rica in 1982). In order to put these welfare costs into context, they are further compared to the costs of autarky and the welfare gains from having free trade agreements and common currencies. The results show that the welfare costs of a single bilateral currency crisis correspond to more than 10% of the costs of autarky for 23 different episodes, up to 41% (for Angola in 1991). These costs are also shown to be more than the welfare gains from having free trade agreements and common currencies (at the time of the crisis) for 25 different episodes.
Abstract
This paper shows that bilateral currency crises reduce bilateral trade up to 50% after controlling for the depreciation rate. Using a trade model, these reductions are connected to the welfare costs of currency crises. The results show that a single currency crisis can result in welfare reductions through changes in international trade corresponding to more than 10% (and up to 41%) of the costs of autarky for 23 different currency crisis episodes between 1960 and 2014. These welfare costs are also shown to be greater than the welfare gains from having free trade agreements and using common currencies for 25 different currency crisis episodes.
The negative effects of having a currency crisis at the country level are well known. These country-level currency crises are mostly identified by using the depreciation of the nominal exchange rate of a country with respect to a vehicle currency such as the U.S. dollar. However, international trade patterns are determined over bilateral exchange rates, since both exporters and importers solve their optimization problems based on their home currencies due to their costs and/or income being subject to these currencies. Therefore, the negative effects of currency crises on international trade can be at the bilateral level, especially when bilateral currency transactions are interrupted due to a crisis.
This paper investigates the possibility that bilateral currency crises (defined over bilateral nominal exchange rates) can affect bilateral imports. This is achieved by using the implications of a trade model, where bilateral currency crises are accepted as additional trade costs due to potential increases in transaction costs. Accordingly, bilateral imports are shown to depend on bilateral currency crises after controlling for the depreciation rate of the importer country's currency with respect to the exporter country's currency. This implication is tested empirically by using bilateral trade data from 66 countries covering the annual period between 1960-2014. The empirical results suggest that having a bilateral currency crisis can reduce international trade up to 50%, depending on the severity of the crisis.
These negative effects of bilateral currency crises are further connected to the corresponding welfare costs by using the implications of the trade model. It is shown that these welfare costs can be measured as the weighted average of the negative effects of bilateral currency crises on international trade, where weights are bilateral import shares. The corresponding empirical results suggest that the welfare costs of a single bilateral currency crisis are up to 2.5% (for Costa Rica in 1982). In order to put these welfare costs into context, they are further compared to the costs of autarky and the welfare gains from having free trade agreements and common currencies. The results show that the welfare costs of a single bilateral currency crisis correspond to more than 10% of the costs of autarky for 23 different episodes, up to 41% (for Angola in 1991). These costs are also shown to be more than the welfare gains from having free trade agreements and common currencies (at the time of the crisis) for 25 different episodes.
The corresponding paper by Hakan Yilmazkuday has been accepted for publication at International Finance.
Free access to the read-only version is available here.