Explaining the volatility of the real exchange rate in emerging markets

This paper shows that the real exchange rate (RER) is more volatile in emerging and developing economies than in advanced countries. This stylized fact is well explained by the correlation coefficient between gross capital inflows (increases in liabilities with the rest of the world) and gross capital outflows (increases in assets held by domestic agents in the rest of the world). This correlation (with increases both in foreign liabilities and assets expressed as positive magnitudes) is much higher in advanced economies than in emerging and developing economies. We find a negative relationship between the correlation coefficient of gross inflows and outflows, on the one hand, and real exchange volatility, on the other. This finding is robust to various estimation procedures and to changes in the definition of RER volatility.