Output volatility and exchange rates: New evidence from the updated de facto exchange rate regime classifications

Abstract

This paper raises the question of whether the exchange rate regime matters for output volatility. Using the two de facto exchange rate regime classifications, we demonstrate that the answer to this question is conditional ‘yes’. The key and novel finding is that the exchange rate regime modifies the importance of determinants of output volatility rather than impacts it directly. This point is explained within a microfounded small open economy model and corroborated with empirical evidence for 48 advanced and emerging market economies. We find that under the pegged regime, trade openness contributes to a reduction in output volatility, whereas financial development has the opposite effect. Moreover, large economies experience lower output volatility irrespective of the exchange rate regime, albeit the beneficial size effect is more pronounced under floating rate regimes. The results are robust to the classification employed to identify de facto pegs and floats.