Exchange Rate Volatility and Euro Area Imports

This paper estimates an import demand function for the euro area vis-a-vis its main extra-area trading partners which takes into account the possible impact of both intra- and extra-euro area exchange rate uncertainty. Our theoretical model captures various mechanisms by which exchange rate volatility may influence the demand for extra-euro area imports. If importers are risk averse, the model predicts not only a negative effect of exchange rate volatility, but also substitution possibilities between extra- and intra-area imports due to differences in the degree of extra- and intra-area exchange rate volatility. Using quarterly data for the past eleven years, panel estimates suggest that extra-area exchange rate volatility may have decreased extra-euro area imports by around 10 per cent. Finally, we also provide some limited evidence that differences in extra- and intra-area exchange rate volatility may have resulted in substitution between extra- and intra-area imports