Do Currency Regime and Developmental Stage Matter for Real Exchange Rate Volatility? A Cross-Country Analysis

This paper analyzes real effective exchange rate (REER) volatility of 18 countries for the post-Bretton Woods period (1973-2004) under the Markov chain model framework. The findings can be summarized as follows: (i) flexible regimes induce higher short-term volatility; (ii) neither currency regime nor developmental stage is found to induce long-term real volatility; and (iii) flexible regimes and lower level of development can help adjust to long-term real shocks. Further investigation suggests that less developed economies adjust to long-term real shocks by deviating from their de jure exchange rate regime. Moreover, estimated steady state probability suggests that REER exhibits more stability in the long run, and it takes around 20 months to converge to equilibrium. In other words, this finding provides an explanation to purchasing power parity (PPP) in relative terms.