Working Paper: CEPR ID: DP2142
Authors: Olivier Jeanne; Andrew K. Rose
Abstract: Both the literature and new empirical evidence show that exchange rate regimes differ primarily by the noisiness of the exchange rate, not by measurable macroeconomic fundamentals. This motivates a theoretical analysis of exchange rate regimes with noise traders. The presence of noise traders can lead to multiple equilibria in the foreign exchange market. The entry of noise traders alters the composition of the market and generates excess exchange rate volatility, since noise traders both create and share the risk associated with exchange rate volatility. In such circumstances, monetary policy can be used to lower exchange rate volatility without altering macroeconomic fundamentals.
Keywords: multiple equilibria; macroeconomic fundamentals; monetary policy; risk; volatility
JEL Codes: F33; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| noise trading (C58) | exchange rate volatility (F31) |
| effective monetary policy (E52) | exchange rate volatility (F31) |
| noise trading (C58) | multiple equilibria (D50) |
| absence of noise traders (G14) | lower exchange rate volatility (F31) |