Nominal exchange rate volatility,relative price volatility,and the real exchange rate

We model real exchange rate, nominal exchange rate, and relative price volatility using real and nominal factors. We analyze these volatility measures across developing and industrialized countries. We find that the inclusion of nominal factors achieves a sizable reduction in the real exchange rate volatility spread between developing and industrialized countries. In addition, we find that nominal factors matter to real exchange rate volatility in the short run and the long run, and that for developing countries, a higher share of real exchange rate volatility stems from relative price volatility.     

Optimal exchange rate flexibility with large labor unions

We study the optimal volatility of the exchange rate in a two-country model with sectoral non-atomistic wage setters, non-traded goods, nominal rigidities and alternative pricing assumptions – producer or local currency pricing. Labor unions internalize the sectoral impact of their wage settlements through firms' labor demand. With local currency pricing, exchange rate depreciation raises sales revenue, which in turn boosts domestic consumption and labor demand. Unions anticipate this effect and set higher wages accordingly. With small unions and low wage markup, optimal monetary policy enhances exchange rate movements to improve its terms of trade. With large unions and high wage markup, optimal monetary policy curbs exchange rate movements to restrain inflationary wage demands and to stabilize employment.     

Real exchange rate persistence and monetary policy rules

The objective of this paper is to analyze the effects of alternative monetary rules on real exchange rate persistence. Using a two-country stochastic dynamic general equilibrium with nominal price stickiness and local currency pricing, we will show how the persistence of purchasing power parity deviations can be related to a monetary theory of these deviations. When monetary policy lean against the wind, there is no relationship of proportionality between the time during which prices remain sticky and the persistence of the response of the real exchange rate: in this case high nominal price rigidity is not sufficient, per se, in generating any persistence following a monetary shock. Moreover, we emphasize the role of interest rates smoothing policies and relative price stickiness within countries in understanding the relationship between the real exchange rate and monetary shocks. With reasonable parameters values, a wide range of monetary policy rules can generate real exchange rate autocorrelations around the ones observed in the data.     

Home bias,exchange rate disconnect,and optimal exchange rate policy

This paper examines how much the central bank should adjust the interest rate in response to real exchange rate fluctuations. The paper first demonstrates, in a two-country Dynamic Stochastic General Equilibrium (DSGE) model, that home bias in consumption is important to replicate the exchange rate volatility and exchange rate disconnect documented in the data. When home bias is high, the shock to Uncovered Interest rate Parity (UIP) can substantially drive up exchange rate volatility while leaving the volatility of real macroeconomic variables, such as GDP, almost untouched. The model predicts that the volatility of the real exchange rate relative to that of GDP increases with the extent of home bias. This relation is supported by the data. A second-order accurate solution method is employed to find the optimal operational monetary policy rule. Our model suggests that the monetary authority should not seek to vigorously stabilize exchange rate fluctuations. In particular, when the central bank does not take a strong stance against the inflation rate, exchange rate stabilization may induce substantial welfare loss. The model does not detect welfare gain from international monetary cooperation, which extends Obstfeld and Rogoff's [Obstfeld, M., Rogoff, K.,2002. Global implications of self-oriented national monetary rules, Quarterly Journal of Economics May, 503–535] findings to a DSGE model.     

US exports and time-varying volatility of real exchange rate

The effect of exchange rate volatility on trade is a controversial issue in international economics. Despite a widespread view that an increase in exchange rates volatility reduces trade, there is no real consensus on the direction or the size of the exchange rate volatility–trade level linkages. This paper investigates the relationship between US trade volume and exchange rate volatility using cointegration and error-correction models. We use conditional variances of the real effective exchange rate (REER) series modeled as a generalized autoregressive conditional heteroskedastic (GARCH) process to measure the exchange rate volatility. The cointegration results indicate a significant negative relationship between US export volume and exchange rate volatility. The short-run dynamics of the relationship, however, show that the effects of both real exchange rates and exchange rate volatility are insignificant.     

Real effective exchange rate volatility and growth: A framework to measure advantages of flexibility vs. costs of volatility

By devising a real effective exchange rate (REER) index where bilateral exchange rates are weighted for relative trade shares, we find that the REER volatility (differently from the bilateral exchange rate volatility with the dollar) has significant impact on growth of per capita income after controlling for other variables traditionally considered in conditional convergence estimates. We also find that this (cost of volatility) effect can be reconciled with the concurring negative and significant effect on growth of the adoption of a fixed exchange rate regime (advantage of flexibility effect), where the latter may be also interpreted as the cost of choosing pegged regimes without harmonization of rules and macroeconomic policies with main trading partners. The adoption of an REER volatility measure, instead of a bilateral exchange rate with the dollar, has the advantage of making it possible a joint test for these two effects. This is because, while fixed exchange rate regimes are strongly negatively correlated, and almost collinear, with bilateral exchange rate volatility with the dollar, the correlation is much weaker when considering our REER volatility measure.     

International price dispersion in state-dependent pricing models

Menu-cost models predict a hump-shaped relationship between real and nominal exchange rate volatility. The hump occurs at higher values of nominal exchange rate volatility, the higher trade costs and lower international substitution elasticities are. These predictions accord well with the negative relationship between relative price and nominal exchange rate volatility I document using a data set of prices collected in Eastern Europe in a volatile environment. In contrast, trade costs must be sufficiently high or international substitution elasticities low in order for the model to account for the positive correlation between real and nominal exchange rate volatility in the aggregate data.     

Technical trading,monetary policy,and exchange rate regimes

The paper extends and empirically tests the noise trader exchange rate model of Jeanne and Rose (2002). We introduce technical trading in the exchange market as a source of noise and explicitly incorporate monetary and exchange rate policy. With these modifications, it is possible to directly test the model's prediction of an U-shaped relation between exchange trend and volatility. We find strong empirical evidence supporting the implications of the model. As a corollary, we develop a measure of excess exchange rate volatility and categorize exchange rate regimes based on the de facto behavior of the exchange rates.     

Technical trading,monetary policy,and exchange rate regimes

The paper extends and empirically tests the noise trader exchange rate model of Jeanne and Rose (2002). We introduce technical trading in the exchange market as a source of noise and explicitly incorporate monetary and exchange rate policy. With these modifications, it is possible to directly test the model's prediction of an U-shaped relation between exchange trend and volatility. We find strong empirical evidence supporting the implications of the model. As a corollary, we develop a measure of excess exchange rate volatility and categorize exchange rate regimes based on the de facto behavior of the exchange rates.     

Adjustment patterns to commodity terms of trade shocks: The role of exchange rate and international reserves policies

We analyze the way in which Latin American countries have adjusted to commodity terms of trade (CTOT) shocks in the 1970–2007 period. Specifically, we investigate the degree to which the active management of international reserves and exchange rates impacted the transmission of international price shocks to real exchange rates. We find that active reserve management not only lowers the short run impact of CTOT shocks significantly, but also affects the long run adjustment of REER, effectively lowering its volatility. We also show that relatively small increases in the average holdings of reserves by Latin American economies (to levels still well below other emerging regions current averages) would provide a policy tool as effective as a fixed exchange rate regime in insulating the economy from CTOT shocks. Reserve management could be an effective alternative to fiscal or currency policies for relatively trade closed countries and economies with relatively poor institutions or high government debt. Finally, we analyze the effects of active use of reserve accumulation aimed at smoothing REERs. The result support the view that “leaning against the wind” is potent, but more effective when intervening to support weak currencies rather than intervening to slow down the pace of real appreciation. The active reserve management reduces substantially REER volatility.     

Nonlinear exchange rate predictability

We study whether the nonlinear behavior of the real exchange rate can help us account for the lack of predictability of the nominal exchange rate. We construct a smooth nonlinear error-correction model that allows us to test the hypotheses of nonlinear predictability of the nominal exchange rate and nonlinear behavior on the real exchange rate in the context of a fully specified cointegrated system. Using a panel of 19 countries and three numeraires, we find evidence of nonlinear predictability of the nominal exchange rate and of nonlinear mean reversion of the real exchange rate. Out-of-sample Theil’s U -statistics show a higher forecast precision of the nonlinear model than the one obtained with a random walk specification. Although the robustness of the out-of-sample results over different forecast windows is somewhat limited, we are able to obtain significant predictability gains—from a parsimonious structural model with PPP fundamentals—even at short-run horizons.     

Understanding the Backus–Smith puzzle: It's the (nominal) exchange rate,stupid

Backus, Kehoe and Kydland (BKK 1992) demonstrated that if international capital markets are complete, consumption growth correlations across countries should be higher than their corresponding output growth correlations. In stark contrast to the theory, however, in actual data the consumption growth correlation is lower than the output growth correlation. By assuming trade imperfections due to non-traded goods, Backus, D.K., Smith, G.W. [1993 Consumption and real exchange rates in dynamic economies with non-traded goods. Journal of International Economics 35(3–4), 297–316] showed that there is an additional impediment at work that can lower the consumption growth correlation. While their argument was successful in partially explaining the puzzlingly low cross country correlation of consumption growth rates, it contributed to generating another puzzle because the data forcefully show that consumption growth is negatively correlated with the real exchange rate, which is also a violation of the theory. Using data for OECD countries, we decompose real exchange rate growth into its nominal exchange rate growth and inflation differential components, and find that nominal exchange rate movements are the main source for the Backus-Smith puzzle. We demonstrate the robustness of this finding by examining sub-samples of the data, by allowing for imperfect risk sharing due to ‘rule of thumb’ consumers, and by examining intranational data across the U.S. states where the nominal exchange rate is fixed.     

Oral intervention in China: Efficacy of Chinese exchange rate communications

This paper analyses China's oral intervention and the efficacy of exchange rate communications by the Chinese monetary authorities. Applying the event study approach, we find that exchange rate communication could help the authorities to impact the Chinese exchange rate level moving in the desired direction. Also, China is responsive to international calls, particularly those from the US calling for the appreciation of the RMB exchange rate. But the response is moderately reluctant as the appreciation would occur after a delay of around two weeks. Finally, using the range-based variance model, confirmative evidence is found that successive, rather than solo, exchange rate communications can calm the exchange rate movement in terms of excess volatility.     

The effect of exchange rate variability on US shareholder wealth

We examine the relationship between financial crisis exchange rate variability and equity return volatility for US multinationals. Empirical analysis of the major financial crises of the last decades reveals that stock return variability increases significantly in the aftermath of a crisis, even relative to the increase in stock return volatility for other firms belonging to the same industry and market capitalization class. In conjunction with this increase in total volatility, there is also an increase in stock market risk (β) for multinational firms. Moreover, trade and service oriented industries appear to be particularly sensitive to these changing exchange rate conditions.     

Why do central banks intervene?

Intervention by central banks, in terms of buying and selling foreign currency, has been a major activity in recent years. This paper investigates the motivations for such policy and the evidence for its effectiveness. We use high quality daily data on the dollar amounts of intervention by the central banks of the US and Germany. We also use information on agreed G7 target levels for the $/DM and $/Yen nominal exchange rates. Daily, nominal dollar exchange rate returns are well described as a Martingale-GARCH process, and we find little evidence that the different types of intervention have had much effect on the conditional mean of exchange rate returns. There is some evidence that intervention is associated with slight increases in the volatility of exchange rate returns. While little evidence is found for the effectiveness of intervention, the motivations are more clear. In particular, from the application of probit analysis we find that the probability of intervention is determined by the magnitude of the deviation of the nominal exchange rate from the agreed target level and, to a lesser extent, by the current volatility of exchange rates.     

Information arrivals and intraday exchange rate volatility

This paper investigates the link between information arrivals and intraday DEM/$ volatility. Information arrivals are measured by the numbers of news items that appeared in the Reuters News Service. We separate news stories into different categories and find that total headline news counts, US and German macroeconomic news and German Bundesbank monetary policy news all have a significant impact on intraday DEM/$ volatility. The larger quantitative effects of the German Bundesbank monetary policy news and US macroeconomic news at 15-min intervals are consistent with the findings of a two-stage adjustment process of public information arrivals [Fleming and Remolona, J. Finance (1999) 1901]. Our results suggest that the persistent of intraday exchange rate volatility set off by public information is extended by traders’ private information about 15 min later. The conclusions are obtained from ARCH models that incorporate intraday seasonal volatility terms.     

Foreign exchange volatility and stock returns

This paper explores whether foreign exchange volatility is a priced factor in the US stock market. Our investigation is motivated by a number of empirical as well as theoretical considerations. Empirically, Menkhoff et al. (2012) find that foreign exchange volatility is a pervasive factor across a variety of test assets. Theoretically, Shapiro (1974), Dumas (1978), and Levi (1990) imply that foreign exchange volatility can influence firms’ cash flow volatility therefore the discount rate. In terms of empirical implementation, we employ the cross-sectional regression methodology of Fama and MacBeth (1973) as well as the time-series regression approach of Fama and French (1996). For robustness, we also use the mimicking portfolio approach of Fama and French (1993). We find that foreign exchange volatility has no power to explain either the time-series or the cross-section of stock returns, which calls for more research on foreign exchange risk. Bartov et al. (1996) and Adrian and Rosenberg (2008) suggest an alternative and maybe promising direction.     

The real exchange rate in the long run: Balassa-Samuelson effects reconsidered

Historical data for over hundred years and 14 countries is used to estimate the long-run effect of productivity on the real exchange rate. We find large variations in the productivity effect across four distinct monetary regimes in the sample period. Although the traditional Balassa-Samuelson model is not consistent with these results, we suggest an explanation of the results in terms of contemporary variants of the model that incorporate the terms of trade mechanism. Specifically we argue that changes in trade costs over time may affect the impact of productivity on the real exchange rate over time. We undertake simulations of the modern versions of the Balassa-Samuelson model to show that plausible parameter shifts consistent with the behavior of trade costs can explain the cross-regime variation of the productivity effect.     

On the sensitivity of the volume and volatility of bilateral trade flows to exchange rate uncertainty

We present an empirical investigation of the hypotheses that exchange rate uncertainty may have an impact on both the volume and variability of trade flows by considering a broad set of industrial countries' bilateral real trade flows over the period 1980–1998. Similar to the findings of earlier theoretical and empirical research, our first set of results shows that the impact of exchange rate uncertainty on trade flows is indeterminate. Our second set of results provides new and novel findings that exchange rate uncertainty has a consistent positive and significant effect on the volatility of bilateral trade flows, helping us better understand macroeconomic volatility.     

Volatility transmission in emerging European foreign exchange markets

This paper studies the dynamics of volatility transmission between Central European (CE) currencies and the EUR/USD foreign exchange using model-free estimates of daily exchange rate volatility based on intraday data. We formulate a flexible yet parsimonious parametric model in which the daily realized volatility of a given exchange rate depends both on its own lags as well as on the lagged realized volatilities of the other exchange rates. We find evidence of statistically significant intra-regional volatility spillovers among the CE foreign exchange markets. With the exception of the Czech and, prior to the recent turbulent economic events, Polish currencies, we find no significant spillovers running from the EUR/USD to the CE foreign exchange markets. To measure the overall magnitude and evolution of volatility transmission over time, we construct a dynamic version of the Diebold–Yilmaz volatility spillover index and show that volatility spillovers tend to increase in periods characterized by market uncertainty.