Soft power and exchange rate volatility

Standard models—based exclusively on macro†financial variables—have made little progress in explaining the behaviour of exchange rates. In this paper, we introduce a neglected set of ‘soft power’ factors capturing a country's demographic, institutional, political, and social underpinnings to shed some light on the ‘missing’ determinants of exchange rate volatility over time and across countries. Based on a balanced panel dataset comprising 115 countries during the period 1996–2015, the empirical results are generally robust across different estimation methodologies and show a high degree of persistence in exchange rate volatility. After controlling for standard macroeconomic factors, we find that the ‘soft power’ variables—such as an index of voice and accountability, life expectancy, educational attainments, fragility of the banking sector, financial openness, and the share of agriculture relative to services—have a statistically significant influence on the level of exchange rate volatility across countries. In other words, countries with greater ‘soft power’ (i.e. better institutional quality) tend to experience a lower degree of exchange rate volatility.