Understanding Bilateral Exchange Rate Volatility

38 Pages Posted: 5 Oct 2002

See all articles by Michael B. Devereux

Michael B. Devereux

University of British Columbia (UBC) - Department of Economics; Centre for Economic Policy Research (CEPR)

Philip R. Lane

Trinity College (Dublin) - Department of Economics; Centre for Economic Policy Research (CEPR); Central Bank of Ireland

Date Written: August 2002

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

JEL Classification: F33, F41

Suggested Citation

Devereux, Michael B. and Lane, Philip R., Understanding Bilateral Exchange Rate Volatility (August 2002). CEPR Discussion Paper No. 3518. Available at SSRN: https://ssrn.com/abstract=336001

Michael B. Devereux (Contact Author)

University of British Columbia (UBC) - Department of Economics ( email )

997-1873 East Mall
Vancouver, BC V6T 1Z1
Canada
604-822-2542 (Phone)
604-946-6271 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Philip R. Lane

Trinity College (Dublin) - Department of Economics ( email )

Trinity College
Dublin 2
Ireland
+353 1 608 2259 (Phone)
+353 1 677 2503 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Central Bank of Ireland ( email )

P.O. Box 559
Dame Street
Dublin, 2
Ireland

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