Exchange Rate Economics: Theories and Evidence

24 Introduction
clusters or that it takes time for market participants to properly process new
information. In Chapter 14,on market microstructure,we consider these interpretations
for volatility clustering. We also postpone considering ARCH and GARCH
estimates of the foreign exchange risk premium until Chapter 15.
1.8.3 Intra- and inter-regime volatility
As we have just seen,one of the key features of a flexible exchange rate regime is the
evident volatility of the exchange rate and it is useful to classify such volatility into
intra- and inter-regime volatility. Intra-regime volatility refers to the perception,
or stylised fact,that in the post-Bretton Woods period nominal exchange rates
are more volatile than a standard set of macroeconomic fundamentals (see,for
example,Frankel and Meese 1987 and MacDonald 1999). One of the key topics
discussed in this book is: can such volatility be explained in terms of traditional
macroeconomic fundamentals or is it necessary to move to non-fundamentals,
such as noise trading and irrational behaviour or have a paradigm shift away
from traditional fundamentals towards the market microstructure interpretation
of exchange rate behaviour (see Chapter 14)? Friedman in his classic 1953 essay
on floating exchange rates cogently argued that excess volatility should be viewed
as a function of instability in the underlying fundamentals:
instability of exchange rates is a symptom of instability in the underlying
economic structure … . a flexible exchange rate need not be an unstable
exchange rate. If it is,it is primarily because there is underlying instability
in the economic conditions.
Although,as we have said,the issues of excess exchange rate volatility is something
of a stylised fact,or widely held belief,in the profession,it is not entirely clear
from an empirical perspective that exchange rates are,in fact,excessively volatile
relative to macroeconomic fundamentals (and this is something we shall return to
in Chapter 7).
One response to the intra-regime volatility argument is to say that if you fix
one price,such as the exchange rate,the volatility that was previously observed
in it will show up elsewhere in the economic system (say,in terms of increased
interest rate volatility). However,the literature on inter-regime volatility suggests
the opposite,namely,as countries move from fixed exchange rate regimes to
flexible exchange rate regimes the volatility of the underlying fundamentals does
not change and all that changes is simply the volatility of the (real and nominal)
exchange rate (see Mussa 1986; Baxter and Stockman 1989; Flood and Rose
1995,1999; MacDonald 1999; Arnold,de Vries and MacDonald 2005). For
example,Baxter and Stockman (1989) examine the variability of output,trade
variables and private and government consumption for both the Bretton Woods
and post-Bretton Woods regimes and they concluded that they were ‘unable to
find evidence that the cyclic behavior of real macroeconomic aggregates depends
systematically on the exchange rate regime. The only exception is the well known
case of the real exchange rate’. In particular,the real exchange rate is around