DP1944 Understanding Exchange Rate Volatility Without the Contrivance of Macroeconomics

Author(s): Robert P Flood , Andrew K Rose

Publication Date: August 1998

Keyword(s): Equilibrium , Frequency , Linear , Monetary , Multiple , Noise , Regime , shock

JEL(s): F33 , G15

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP1944.asp

Exchange rate regimes differ primarily by the activity of the exchange rate, not observable macroeconomic ‘fundamentals’. Fixed exchange rates are typically stable and floating exchange rates are volatile, but macro phenomena are regime-independent. Fundamentals only seem to be relevant for exchange rates at low frequencies or when inflation is high. A basic task of international finance is explaining these cross-regime differences in exchange rate volatility. The evidence suggests that a switch in exchange rate policy is accompanied by a change in market structure; macroeconomic considerations are superfluous. We formalize this observation in a non-linear model with multiple equilibria.