Currency Networks, Bilateral Exchange Rate Volatility and the Role of the US Dollar

Abstract

We investigate monthly bilateral exchange rate volatility for a large sample of currency pairs over the period [1999][2000][2001][2002][2003][2004][2005][2006]. Pegs (particularly to the US dollar) and managed floats tend to have lower volatility than independent floats. A deeper investigation shows that the peg effect operates almost entirely through currency networks (i.e. where two currencies are pegged to the same anchor currency), and the lower volatility of US dollar pegs reflects the size of the US dollar network. Managed floats show clear evidence of tracking the US dollar, further increasing the effective size of the US dollar network. Inflation undermines the currency-stabilizing effect of peg networks. Currencies in smaller peg networks have higher unweighted but not trade-weighted exchange rate volatility, which is consistent with anchors being chosen to minimize trade-weighted volatility. The size of the effective US dollar network revealed here is a plausible explanation of the rarity of basket pegs. Volatility also reflects a range of structural factors such as country size, level of development, population density, inflation differentials and business cycle asymmetry.

De Facto Exchange Rate Regime Classifications: An Evaluation

“…When it comes to floats, it is important to recognise that bilateral exchange rate volatility increases with distance, and that at the aggregate level both nominal and real effective exchange rate volatility increase with remoteness (weighted-average distance from trading partners) (Bleaney and Tian, 2012;Bravo-Ortega and di Giovanni, 2006).…”

The Exchange Rate Dimension of Inflation Targeting: Target Levels and Currency Volatility

“…Our contribution to the literature which studies the association between the level of inflation and exchange rate volatility is to identify the difference in exchange rate volatility experienced by inflation targeting countries that target high and low levels of inflation, after controlling for the average level of inflation and other control variables. Our result uses an institutional fact, the target level under an inflation targeting system, to draw together the somewhat disparate results of Rose (), Berganza and Broto (), and Bleaney and Tian (). It also yields a policy relevant result that the target level for inflation is not unconnected from the monetary policy regime's realised currency volatility.…”

“…From an econometric perspective, the literature on currency volatility can be divided into time series and cross‐sectional studies. In the cross‐sectional literature, we are particularly interested in Bleaney and Tian () as well as Bleaney and Francisco () who include inflation among the macroeconomic fundamentals to explain the cross‐sectional distribution of exchange rate volatility.…”

“…They used time series data to show that inflation targeting emerging market economies have experienced higher exchange rate volatility. In the cross‐sectional literature on currency volatility, Bleaney and Tian () have meanwhile connected the level of inflation with currency volatility.…”

“…We build on Bleaney and Tian's () cross‐sectional approach to investigate the association between the level at which inflation targeting countries target inflation and exchange rate volatility over the long run . To this end, we use a cross‐section of developed and emerging countries covering the 20+ years of the inflation targeting era.…”