Most countries currently manage their exchange rates in some way and have done so historically, because this substantially reduces their volatility. In most models, this volatility transfers to other economic variables, such as the money supply. In Discussion Paper No. 838, Robert Flood and Research Fellow Andrew Rose argue that exchange rate volatility does not transfer elsewhere in the economy but simply vanishes when rates are fixed: the volatility of other macroeconomic variables such as money and output does not differ significantly across fixed and floating rate regimes. They consider the implications of exchange rate volatility in regimes of fixed and floating rates for typical OECD countries.

Flood and Rose note that exchange rates are usually modelled as linear functions of `fundamental' variables, while conditional exchange rate volatility necessarily depends on the exchange rate regime. This allows the identification of exchange rates' possible determinants and the early elimination of models that cannot be empirically valid. If the relationship of exchange rates with fundamentals is structural and does not change dramatically across regime types, the conditional volatility of a previously fixed rate will typically rise dramatically whenever it begins to float; any potentially valid fundamental determinant must therefore then experience a similar rise in its conditional volatility.
Empirically, however, there are no macroeconomic variables whose volatility characteristics even approximately mimic those of OECD exchange rates, so macroeconomic variables will not be able to explain much of their volatility. Neither existing monetary models nor any potential models that depend on such variables can pass the authors' test, which drives them to conclude that the most critical determinants of exchange rate volatility are not macroeconomic. There is no clear trade-off between the reduction of exchange rate volatility and the achievement of macroeconomic stability.

Fixing Exchange Rates: A Virtual Quest for Fundamentals
Robert P Flood and Andrew K Rose

Discussion Paper No. 838, September 1993 (IM)