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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. Silvana Tenreyro & Robert J. Barro, 2002. "Economic effects of currency unions," Working Papers 02-4, Federal Reserve Bank of Boston.
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  21. 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.
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