Measuring the costs of exchange rate volatility

Many countries go to great lengths to manage their exchange rates. Probably the most prominent recent example is the European Monetary Union, where all the members abandoned their national currencies and adopted the euro. A number of developing countries maintain other kinds of regimes of managed exchange rates, even though they face potent market pressures to let their exchange rates float. One of the main motives for these arrangements stems from the extreme volatility of exchange rates. This volatility introduces an element of uncertainty into doing business across borders. Arguably, this uncertainty hinders international trade and, therefore, takes a toll in terms of economic welfare. ; Recent work in economics has turned to re-examining the question of whether having a stable exchange rate is worth these efforts. This research has used new tools to assess the economic welfare costs of exchange rate volatility. Specifically, the aim is to measure the costs of exchange rate volatility as a loss in the utility that people expect on average over time. This Economic Letter summarizes this literature and draws preliminary conclusions.