On the Macroeconomic Causes of Exchange Rate Volatility

Abstract

What are the causes of exchange rate volatility? When second moments implications of theories of exchange rates determination are considered, long-term fundamental linkages between macroeconomic and exchange rate volatility can be envisaged. Moreover, as the exchange rate is an important determinant of aggregate demand, bidirectional causality should be expected. The results of the paper support the above intuitions pointing to important linkages and trade-offs relating exchange rate and macroeconomic volatility, with causality direction stronger from macroeconomic volatility to exchange rate volatility than the other way around. An out of sample forecasting exercise shows how conditioning on macroeconomic information does improve medium- to long-term volatility forecasting.

Keywords: exchange rates volatility, macroeconomic volatility, long memory, structural change, fractional cointegration, cobreaking, fractionally integrated factor vector autoregressive model, G-7 area

JEL Classification: C22, F31, E44, E52