Floating exchange rates are more volatile than exchange rates which are fixed within bands by governments. The question is whether governments merely transfer the volatility elsewhere in the economy when they smooth exchange rates? Or does a regime of fixed exchange rates reduce total economic volatility, smoothing exchange rates but having few effects elsewhere in the economy?

In Discussion Paper No. 1240, Research Fellow Andrew Rose addresses the issue of whether regimes of fixed exchange rates are a mechanism for shifting volatility inter-temporally. He searches for signs that volatility is transferred over time from periods of fixed exchange rates to periods after the regime breaks down, using a panel of data covering 20 industrialized countries from 1959-93 to examine volatilities with graphical and statistical analysis of the periods around 33 floatations and 81 devaluations. He then compares the volatility of 25 different variables up to three years before and after the actual exchange market event, using both graphical and statistical techniques. His empirical results suggest that it seems more plausible that fixed exchange rates reduce exchange rate volatility than that they are a mechanism for shifting the underlying volatility over time.

After the Deluge: Do Fixed Exchange Rates Allow Inter-temporal Volatility Trade-offs?
Andrew K Rose

Discussion Paper No. 1240, September 1995 (IM)