FUNDAMENTALS AND EXCHANGE RATE VOLATILITY

Abstract

Fundamentals may determine the range of real exchange rate fluctuation, through signals of misalignment, even if they are not a major influence on the level within that range. This can explain the puzzle that more open economies experience lower real exchange rate volatility. Adjustment of domestic prices to nominal exchange rate movements can account for only a small proportion of this effect. Sustainability analysis focuses on the ratio of the current account to GDP (rather than to total trade flows) as a misalignment signal, which implies narrower bounds for real exchange rates in more open economies.