Abstract
It is widely agreed that when moving from fixed to floating exchange rates the increase in exchange rate volatility is not matched by an equivalent rise in the volatility of fundamentals. We argue and demonstrate that in inter-regime comparisons one has to account for ‘missing variables’ that compensate for the fundamental variables’ volatility under fixed exchange rates. Previous studies have often used foreign exchange reserves, but without much success. We argue why reserves are not a reliable measure, while IMF credit support is. Our empirical analysis identifies IMF support as a crucial and significant compensating variable.
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