Exchange Rate Uncertainty and Business Cycle Fluctuations

What is the impact of heightened exchange rate uncertainty on business cycle dynamics? This question is particularly important for emerging economies where exchange rate uncertainty is substantially higher and time-varying. Using data from emerging countries, we show that exchange rate uncertainty is essential for business cycle fluctuations. We find that heightened exchange rate uncertainty yields a drop in economic activity, an increase in prices, and an exchange rate depreciation. We rationalize our empirical findings in a small open economy model augmented with time-varying volatility of exchange rate shocks. In the structural model, the main ingredient of the transmission mechanism is the households’ precautionary behavior. We also show that no other shocks, often featured in the literature, can produce the reported co-movement pattern among the macro variables.