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Understanding Bilateral Exchange Rate Volatility

This paper develops an empirical model of bilateral exchange rate volatility. We conjecture that for developing economies, external financial liabilities have an important effect on desired bilateral exchange rate volatility, above and beyond the standard Optimal Currency Area (OCA) factors. By contrast, industrial countries do not face the same set of constraints in international financial markets. In our theoretical model, external debt tightens financial constraints and reduces the efficiency of the exchange rate in responding to external shocks. We go on to explore the determinants of bilateral exchange rate volatility in a broad cross section of countries. For developing economies, bilateral exchnage rate volatility (relative to creditor countries) is strongly negatively affected by the stock of external debt. For industrial countries however, OCA variables appear more important and external debt is generally not significant in explaining bilateral exchange rate volatility.

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File URL: http://www.tcd.ie/Economics/TEP/2002_papers/TEPNo11PL22.pdf
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Paper provided by Trinity College Dublin, Department of Economics in its series CEG Working Papers with number 20025.

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Date of creation: 2002
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Handle: RePEc:tcd:tcdceg:20025
Contact details of provider: Postal: Trinity College, Dublin 2
Phone: (+ 353 1) 6081325
Fax: 6772503
Web page: http://www.tcd.ie/Economics/

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  1. Lane, P, 1999. "The New Open Economy Macroeconomics: A Survey," Trinity Economics Papers 993, Trinity College Dublin, Department of Economics.
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  5. Mark Gertler & Simon Gilchrist & Fabio Natalucci, 2001. "External constraints on monetary policy and the financial accelerator," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
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  8. Alberto Alesina & Robert J. Barro, 2000. "Currency Unions," NBER Working Papers 7927, National Bureau of Economic Research, Inc.
  9. Carmen M. Reinhart & Kenneth S. Rogoff, 2002. "The Modern History of Exchange Rate Arrangements: A Reinterpretation," NBER Working Papers 8963, National Bureau of Economic Research, Inc.
  10. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," Journal of Political Economy, University of Chicago Press, vol. 103(3), pages 624-60, June.
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  12. Frankel, Jeffrey A & Rose, Andrew K, 1998. "The Endogeneity of the Optimum Currency Area Criteria," Economic Journal, Royal Economic Society, vol. 108(449), pages 1009-25, July.
  13. Banerjee, Abhijit & Bacchetta, Philippe & Aghion, Philippe, 2001. "Currency Crises and Monetary Policy in an Economy with Credit Constraints," Scholarly Articles 4554218, Harvard University Department of Economics.
  14. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
  15. Eichengreen, Barry, 2002. "When to Dollarize," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 34(1), pages 1-24, February.
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  18. John Shea, 1996. "Instrument Relevance in Multivariate Linear Models: A Simple Measure," NBER Technical Working Papers 0193, National Bureau of Economic Research, Inc.
  19. Barry Eichengreen & Ricardo Hausmann, 1999. "Exchange Rates and Financial Fragility," NBER Working Papers 7418, National Bureau of Economic Research, Inc.
  20. International Monetary Fund, 2000. "Spillovers Through Banking Centers; A Panel Data Analysis," IMF Working Papers 00/88, International Monetary Fund.
  21. Honohan, Patrick & Lane, Philip R, 1999. "Pegging to the Dollar and the Euro," International Finance, Wiley Blackwell, vol. 2(3), pages 379-410, November.
  22. Hausmann, Ricardo & Panizza, Ugo & Stein, Ernesto, 2001. "Why do countries float the way they float?," Journal of Development Economics, Elsevier, vol. 66(2), pages 387-414, December.
  23. Bayoumi, Tamim & Eichengreen, Barry, 1998. "Exchange rate volatility and intervention: implications of the theory of optimum currency areas," Journal of International Economics, Elsevier, vol. 45(2), pages 191-209, August.
  24. Luis Felipe Cespedes & Roberto Chang & Andres Velasco, 2000. "Balance Sheets and Exchange Rate Policy," NBER Working Papers 7840, National Bureau of Economic Research, Inc.
  25. Ricardo Caballero & Arvind Krishnamurthy, 2001. "A "Vertical" Analysis of Crises and Intervention: Fear of Floating and Ex-ante Problems," NBER Working Papers 8428, National Bureau of Economic Research, Inc.
  26. Claudia M. Buch, 2001. "Distance and International Banking," Kiel Working Papers 1043, Kiel Institute for the World Economy.
  27. Hélène Poirson, 2001. "How Do Countries Choose their Exchange Rate Regime?," IMF Working Papers 01/46, International Monetary Fund.
  28. Engel, Charles M & Rose, Andrew K, 2001. "Currency Unions and International Integration," CEPR Discussion Papers 2659, C.E.P.R. Discussion Papers.
  29. Larrain Felipe & Jose Tavares, 2003. "Regional Currencies Versus Dollarization: Options for Asia and the Americas," Journal of Economic Policy Reform, Taylor & Francis Journals, vol. 6(1), pages 35-49.
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