Identifying the External and Internal Drivers of Exchange Rate Volatility in Small Open Economies

This paper estimates a 3-country DSGE model to identify the drivers of exchange rate volatility in small open economies (SOE). The model features common shocks that affect economies symmetrically. Using data from Jamaica, the US and the G-7 region, the paper finds that external financial shocks are the primary drivers of exchange rates. While domestic financial shocks are bigger contributors than US and G-7 specific shocks, shocks that are common across the US and G-7 play the main role. Nonfinancial shocks are inconsequential for exchange rates. Inferences from a vector autoregressive model with exogenous variables are consistent with these results