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Understanding Bilateral Exchange Rate Volatility

  • Michael B. Devereux
  • Philip R. Lane

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 Trinity Economics Papers with number 200211.

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Date of creation: 2002
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Handle: RePEc:tcd:tcduee:200211
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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  2. Frankel, Jeffrey A & Rose, Andrew K, 1996. "The Endogeneity of the Optimum Currency Area Criteria," CEPR Discussion Papers 1473, C.E.P.R. Discussion Papers.
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  4. Silvana Tenreyro & Robert J. Barro, 2003. "Economic Effects of Currency Unions," NBER Working Papers 9435, National Bureau of Economic Research, Inc.
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  22. Luis Felipe Céspedes & Roberto Chang & Andrés Velasco, 2004. "Balance Sheets and Exchange Rate Policy," American Economic Review, American Economic Association, vol. 94(4), pages 1183-1193, September.
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  24. 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.
  25. Hélène Poirson, 2001. "How Do Countries Choose their Exchange Rate Regime?," IMF Working Papers 01/46, International Monetary Fund.
  26. 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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  28. 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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