Yang Guangpu1, Gu Qingyang2

(1. Department of Economics, National University of Singapore;

2. Lee Kuan Yew School of Public Policy, National University of Singapore)

 

 

Abstract: In this paper, we propose a new approach to resolve the potential reversal causality problem with assessing the effects of exchange rate volatility on bilateral trade flows. The approach is based on the introduction of the triangular-arbitrage-free exchange rates, through which the bilateral exchange rate between the trade partners could be decomposed into a pair of bilateral exchange rates of these two currencies to a third currency. Using a novel monthly bilateral-trade dataset between China and Singapore over 21 years, from 1993 to 2013, we not only empirically show the advantage of our new approach in correcting the biased estimation resulting from the conventional approach, but also figure out the mechanism of the true effects of interest.

 

 

Key words: triangular-arbitrage-free exchange rates; volatility; bilateral trade

 

JEL codes: F14, F31, F32