Understanding Bilateral Exchange Rate Volatility

Philip Lane and Michael Devereux

No 3518, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: 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 exchange 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.

Keywords: Exchange rate volatility; Optimal currency area; Financing constraints (search for similar items in EconPapers)
JEL-codes: F33 F41 (search for similar items in EconPapers)
Date: 2002-08
New Economics Papers: this item is included in nep-ifn
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Citations: View citations in EconPapers (9)

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