Trade Flows and Volatility of Their Fundamentals: Some Evidence from Mexico

Abstract: In this paper we investigate the effects of volatility of the fundamental determinants of trade on trade flows in México during the period 1991-2008. Our import and export functions are based on the well known imperfect substitute goods model of trade. We focus on the effects of real exchange rate as well as measures of relative prices and real income and their associated conditional volatility on import and export flows. We consider a vector error-correction model with conditional heteroskedasticity (VECGARCH). Our results indicate that the imperfect substitute goods model is a reasonable empirical specification as we find evidence supporting cointegration and obtain income and price elasticities in line with those from previous empirical studies. Quantitatively, we find that while income effects are the most important determinants of trade flows in the long run, there are some non-negligible volatility effects of fundamentals on the short run dynamics.