The financial crisis has ratcheted up a dangerous notch. The currency markets have gone topsy-turvy. The authorities now have to make some pretty big and delicate moves – something like performing microsurgery in a plane in turbulent skies. The yen has risen by 40 percent against the euro since August, with most of that occurring in
October. This month, the Australian dollar has also fallen by 25 percent and the pound by 16 percent against the American dollar. Swings of this scale are alarming when they happen in the stock market. But they are petrifying in currency markets,
because they make it virtually impossible to price exports or imports. What's going on? Edward Hadas and Hugo Dixon. New York Times, October 27, 2008.
The volatility of the exchange rate is an important policy variable, particularly for many export-oriented economies. For instance, while many countries have de jure free-floating regimes, they are often seen intervening in foreign exchange markets to smooth fluctuations of the nominal exchange rate. This fear of floating is well- documented in, e.g., Reinhart (2000), Fischer (2001), Calvo and Reinhart (2002) and Reinhart and Rogoff (2004). Moreover, a country that suddenly increases its interest rate may be expected to attract foreign capital in the short-run, which in a frictionless world, would lead to an immediate appreciation of the currency. Depending on the reason for this relative interest rate increase (does it reflect shifts in relative productivity or an attempt to stump demand-driven inflation?) a central bank may face tough choices that reflect the difficulties of reconciling conflicting goals (see, e.g. Obstfeld, Shambaugh and Taylor, 2005; or Aizenman, Chinn, and Ito, 2008).
On the other hand, low exchange-rate volatility is often blamed for inducing investors to take on excessive carry trade risks (see, e.g. Mishkin, 1997; Goldstein, 2002; and Kawai and Lamberte, 2008). Here, the carry trade refers to a strategy in which the investor tries to profit from the interest rate differential between two countries while bearing the risk of countervailing exchange rate movements. While the