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Explaining the Great Moderation Exchange Rate Volatility Puzzle

Author

Listed:
  • Vania Stavrakeva

    (London Business School)

  • Jenny Tang

    (Federal Reserve Bank of Boston)

Abstract

We study how macroeconomic volatility relates to trends in exchange rate volatility through the prism of the Great Moderation hypothesis. We find significant heterogeneity in exchange rate volatility trends across advanced economy currencies against the USD. Financial centers currencies became less volatile over a 50-year history, while commodity currencies became more volatile. This occurred despite decreases in the volatility of macroeconomic variables, particularly expected interest rate differentials. Instead, trends in the volatility of non-macro (currency risk premium) exchange rate components were a main driver of patterns in exchange rate volatility. However, the behavior of macroeconomic variables still mattered greatly for explaining the rise in commodity currency volatility. We document that a meaningful part of this increasing volatility can be tied to less negative co-movements over time between changes in expectations of relative interest rates and changes in expectations of excess returns – a pattern that is consistent with a weakening or even disappearance of the Fama puzzle for commodity currencies.

Suggested Citation

  • Vania Stavrakeva & Jenny Tang, 2025. "Explaining the Great Moderation Exchange Rate Volatility Puzzle," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 73(1), pages 196-238, March.
    • Handle: RePEc:pal:imfecr:v:73:y:2025:i:1:d:10.1057_s41308-024-00264-9
    DOI: 10.1057/s41308-024-00264-9
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    More about this item

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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