It is commonly understood that the determinants of competitiveness are varied and complex, and spring from micro, macro and institutional levels, as also from the monetary and the real side of the economy. A key link between micro and macro, and also between real and financial is the exchange rate. Exchange rates link macroeconomic policies and exogenous events to sector and firm level outcomes; they link financial developments to output and employment; they alter international goods and financial flows and in turn are altered by these flows.
This chapter conceptualizes these linkages into four 'cells', as shown in the table below.
Short-term exchange rate movements
Long-term movements (i.e. persistent deviations from equilibrium)
The bulk of this chapter concentrates on the first row of the table, surveying the issues around the matter of the effect of short-term and long-term exchange rate volatility on international trade. These effects are relatively one way, meaning exchange rates have the potential to alter trade flows, but increasingly it is clear that the classical view of the exchange rate being determined by goods flows is less likely. The relationships in the second row, on the other hand, are likely two way and are examined at the end of the chapter; and equally importantly (though not the subject of this chapter), investment flows in turn determine trade flows.
Section 2 argues that exchange rate variability is a relevant issue in trade modelling, while Section 3 outlines the 'standard' model that is used in most studies. Section 4 addresses some general issues that arise from the model, while Section 5 concentrates on how to define and measure exchange rate variability. Section 6 presents financial flows and Section 7 some concluding remarks.