Impacts of Exchange Rate Volatility on Macroeconomic and Financial Variables: Empirical Evidence from PVAR Modeling

Abstract

In this study, Panel Vector Autoregression (PVAR) models are used to determine the impacts of exchange rate volatility on industrial production growth rate, consumer price inflation, short-term interest rates and stock returns for 10 OECD countries. The variance decomposi- tions (VDCs) found that exchange rate volatility can be a secondary factor for the variations in immediate interest rates, implying that Uncovered Interest Rate Parity (UIP) condition should be analyzed by the inclusion of other macroeconomic variables. Impulse response functions (IRFs) expose that volatility in exchange rates can have a positive impact on the liquidity conditions in money market and an increase in real economic activity because investors have to move their money away from currency markets to money markets. The relatively lower impact of exchange rate volatility may arise from the zero bound problem, thus it is emphasized that the examination of impacts on exchange rate volatility on macro- economics variables should be made both considering conventional and unconventional monetary policy. Although impulse response functions (IRFs) did not detect the significant impact of exchange rate volatility on inflation, VDCs obtained supporting results to exchange rate pass-through (ERPT). I suggest that the monetary policy to be developed should clarify alternative channels that exchange rate may affect inflation.