Exchange rate regimes and volatility

The perception is widespread that foreign exchange rates are too volatile. In 1992, for example, the U.S. dollar rose more than 2 percent against the German mark in one day on seven separate occasions. While a 2 percent daily change may seem small, it nonetheless amounts to a change of more than 500 percent at an annual rate. High volatility in exchange rates can have important adverse consequences. If investors equate volatility with risk, they may alter their investment decisions. As a result, long-term capital flows may be reduced, thereby retarding the efficient fiow of capital in the world economy. Moreover, if the exchange value of foreign sales becomes more volatile, firms may be reluctant to engage in international trade. And, if exchange rate volatility spills over into the real economy or inhibits the smooth functioning of the financial system, monetary policymakers will be less able to achieve their policy goals. To reduce exchange rate volatility, some observers recommend that the United States, Japan, and Germany abandon their system of flexible exchange rates and adopt a target zone system. Under a target zone system, exchange rates are fixed within a narrow band that can be periodically adjusted, or realigned. Exchange rates are kept within a target zone in the European Monetary System (EMS). The European experience has shown, however, that a new kind of exchange rate volatility is introduced under this system due to the possibility of exchange rate realignments. Since the fall of 1992, European foreign exchange markets have been in intermittent turmoil, with realignments in September and November of last year and January and May of this year. This article examines the European experience with a target zone system to learn whether a target zone for the U.S. dollar, yen, and mark would reduce exchange rate volatility. The first section of the article shows that exchange rate volatility is different for EMS and non-EMS countries, which supports the view that volatility in a target zone would be different from volatility in a flexible exchange rate regime. The next two sections provide reasons why volatility is dierent in the two kinds of exchange rate regimes. The article concludes that exchange rate volatility would probably not decline if the United States, Japan, and Germany were to adopt a target zone system. VOLATILITY OF EMS AND NON-EMS EXCHANGE RATES How can volatility in a system of flexible exchange rates be compared with volatility in a system of fixed, but adjustable, exchange rates? One approach is to compare the volatility of the dollar/mark exchange rate under the current fiexible rate system with its volatility during the fixed, but adjustable, Bretton Woods system prevailing after World War II. This comparison may be misleading, however, since the current environment is significantly different from the 1950s and 1960s. A preferred approach is to compare dollar/mark volatility with French franc/mark volatility in the current period, since the French franc/mark exchange rate belongs to the EMS target zone. More generally, comparing volatility of non-EMS exchange rates, such as the dollar/mark rate, with volatility of EMS exchange rates, such as the franc/mark rate, can provide information about how exchange rate volatility might change if the United States, Japan, and Germany adopted a target zone system. Accordingly, this section first discusses how to measure exchange rate volatility and then compares the volatility of eight EMS and non-EMS currencies. Most of the discussion focuses on two exchange rates, the dollar/mark and French franc/mark. Results are also reported for four other EMS exchange rates--the Italian lira, Belgian franc, Danish krone, and Dutch guilder--and two other non-EMS exchange rates--the Canadian dollar and Japanese yen. All currencies are measured relative to the Deutsche mark because Germany is the largest European country. …