Persistent Trade Effects of Large Exchange Rate Shocks

This paper presents a theoretical basis for the argument that large exchange rate shocks—such as the 1980s dollar cycle—may have persistent effects on trade flows and the equilibrium exchange rate itself. We begin with a partial-equilibrium model in which large exchange rate fluctuations lead to entry or exit decisions that are not reversed when the currency returns to its previous level. Then we develop a simple model of the feedback from hysteresis in trade to the exchange rate itself. Here we see that a large capital inflow, which leads to an initial appreciation, can result in a persistent reduction in the exchange rate consistent with trade balance.