Variance Bounds as Thresholds for ‘Excessive’ Currency Volatility: Inflation Targeting Emerging Economies

At what level does a currency’s volatility become ‘excessive’, in a concrete sense? Any claim that an exchange rate is excessively volatile needs a benchmark for ‘normal’variability. We compute variance bounds implied by exchange rate models as the norm, for a set of particularly volatile emerging market currencies; and a…nd that long-run exchange rate volatility does not breach the upper bound implied by the present value of underlying fundamentals –for each currency in our sample, except the Brazilian real. However, nominal exchangerate variances get closer to implied upper bounds under in‡inflation targeting. We also find a reduction in real exchange rate misalignment under inflation targeting.