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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
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Web page: http://www.tcd.ie/Economics/

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  1. Aghion, Philippe & Bacchetta, Philippe & Banerjee, Abhijit, 2001. "Currency crises and monetary policy in an economy with credit constraints," European Economic Review, Elsevier, vol. 45(7), pages 1121-1150.
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  13. Luis Felipe Céspedes & Roberto Chang & Andrés Velasco, 2002. "Dollarization of Liabilities, Net Worth Effects, and Optimal Monetary Policy," NBER Chapters, in: Preventing Currency Crises in Emerging Markets, pages 559-600 National Bureau of Economic Research, Inc.
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  19. 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.
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  25. 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.
  26. 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.
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  28. 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.
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