Working Paper: CEPR ID: DP3518
Authors: Michael B. Devereux; Philip R. Lane
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; financing constraints; optimal currency area
JEL Codes: F33; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| stock of external debt (F34) | bilateral exchange rate volatility (F31) |
| financial linkages (F65) | bilateral exchange rate volatility (F31) |
| stock of external debt (F34) | financial linkages (F65) |
| bilateral exchange rate volatility (F31) | creditor countries (F34) |