Volatility of macro fundamentals across exchange rate regimes : a theoretical exploration

This paper seeks a novel theoretical support for the analysis of volatility changes in macro fundamentals with a shift in exchange rate regime by incorporating Rotemberg’s sticky-price adjustment rule and the forward-looking Taylor monetary reaction function into a stochastic dynamic Mundell-Fleming framework. The model predicts that, with flexible prices, output and real exchange rate exhibit the same variability after a shift. Interest rates are more volatile and the inflation rate is less volatile under the float. With fixed prices, inflation and the interest rate volatility are unchanged. The real exchange rate is more volatile under the float. Volatility in output and money co-moves. Our theoretical findings shed some light on the diverse empirical results in the literature—exchange rate regime shift does not lead to a uniform change in macro volatility; country-specific factors such as the degree of price rigidity, among others, are influential as well.