July 25, 2003 Straub Roland presents a paper: Non-Fundamental Exchange Rate Volatility and Welfare

Abstract

July 25, 2003

Straub Roland(European University Institute)

Non-Fundamental Exchange Rate Volatility and Welfare

We lay out an empirical and a theoretical model to analyze the effects of non-fundamental exchange rate volatility on economic activity and welfare. In the first part of the paper, the GARCH-SVAR model is applied to measure empirically the effect of the conditional exogenous exchange rate volatility on the conditional mean of the endogenous variables in our open economy VAR. Our results for Canada, Germany and UK indicate that the effects of exchange rate uncertainty are small empirically. In the second part, we investigate the effect of non-fundamental exchange rate volatility in a stochastic open economy model. The second order approximation method of Sims [2000] is applied to the model equilibrium conditions. We show that in a model with habit persistence, even non-fundamental exchange rate shocks that generate only small variation in the unconditional mean of the variables might induce economically significant welfare changes.