Working Paper: NBER ID: w3570
Authors: Giancarlo Corsetti; Vittorio Grilli; Nouriel Roubini
Abstract: This paper investigates the relationship between international capital liberalization and exchange rate volatility. While the effects of a capital controls liberalization on the transaction volume in the foreign exchange market are theoretically unambiguous, the effects on the volatility of exchange rate can have either sign. On one hand, the liberalization leads to increasing economy-wide and investor-specific uncertainty. On the other hand, the augiented number of participants in the market should reduce exchange rate fluctuations. The uncertainty effects should be dominant in the short run, while the increase in the number of traders in the longer run should make the market thicker and tend to reduce volatility. It is shown that, for a sample of countries which have liberalized capital controls in the last 15 years, structural breaks in the process generating exchange rate volatility have occurred very close to the time when liberalization measures were implemented. The results also suggest an increase in volatility after the structural breakpoint.
Keywords: exchange rate volatility; capital liberalization; foreign exchange market
JEL Codes: F31; F36
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Capital liberalization (F21) | Increase in transaction volume (F69) |
| Capital liberalization (F21) | Increase in exchange rate volatility (short run) (F31) |
| Increase in uncertainty (D89) | Increase in exchange rate variance (F31) |
| Increase in transaction volume (F69) | Change in price variability (E39) |
| Increase in number of traders (F19) | Decrease in exchange rate volatility (long run) (F31) |
| Increase in exchange rate volatility (short run) (F31) | Decrease in exchange rate volatility (long run) (F31) |