behavior of currency is also predicted by the new open economy macro models _à la_ Obstfeld and Rogoff (1995), where an increase in domestic output relative to foreign output leads to a depreciation of the exchange rate—a positive productivity shock increases the volume of the domestically produced varieties and decreases their relative price.

The empirical literature does not provide any clear guidance either on the relationship between economic activity and exchange rate behavior. The lack of a clear pattern between the growth rates of consumption and the real exchange rate is documented by Backus and Smith (1993) and subsequently by Chari et al. (1992) and Corsetti et al. (2002). Despite some important progress in empirical exchange rate modeling (see, for instance, Engel et al., 2008), the current knowledge on the behavior of exchange rate and its determinants remains quite limited (Rogoff, 2009).

We calculate the CCI using quarterly data for 63 countries over a period of 30 years. Following an identification strategy similar to that in KRV, we assume that the business cycle is driven by the capital flows that the countries receive and by their dependence on commodity exports; we also assume that these exogenous factors affect the CCI. We recognize that the relationship between these factors and the CCI is influenced by the institutional arrangements within the country such as the choice of the exchange rate regime and the degree of openness of its capital account; we discuss how the CCI affects the stance of monetary policy; and how these relationships have evolved over time.

We show that the countries that are commodity exporters and experience procyclical capital flows tend to have more procyclical currencies. This implies that currency procyclicality is more likely to be a feature of emerging economies, rather than of advanced countries, since the latter have more diversified exports and possibly experience less procyclical capital flows (due to “fly to quality” considerations).

While our results do not indicate any clear welfare implications of a particular degree of cyclicality, they underscore that the degree of currency cyclicality has important implications for the pursuit of macroeconomic policies, especially in emerging economies. Specifically, our results indicate that the countries with procyclical currencies tend to limit the degree of procyclicality by restricting their capital accounts. This partly reflects their fear of floating—that is, their intolerance to excessive variation in exchange rates (Calvo and Reinhart, 2002). The same fear of floating is reflected in a positive correlation between the procyclicality of currency and monetary policy. We observe that the countries with more procyclical currencies tend to pursue more procyclical monetary policy. Our final observation is that in the last decade a disconnect has emerged between the procyclicality of the currency and that of the monetary policy; this can be partially explained by an improvement in the countries’ net foreign asset position, translating into reduced fear of floating.

Before proceeding further, an important _caveat lector_ is in order. Even though our analysis provides new interesting perspectives on the interaction between the exchange rate movements and policy challenges, the nature of the available data does not allow us to establish causality. It is thus 3