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: cepr.org/active/publications/discussion_papers/dp.php?dpno=1944

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.