Research Discussion Paper – RDP 8608 Exchange Rate Regimes and the Volatility of Financial Prices: The Australian Case
July 1986
Abstract
Much has been written about the choice of exchange rate regimes from a theoretical perspective. A conclusion of this literature is that, ceteris paribus, interest rates should exhibit less volatility (and exchange rates more volatility) under a floating than under a fixed exchange rate regime. Equivalently, interest rates should be relatively easier (and exchange rates relatively harder) to predict (in the statistical sense) under a floating exchange rate. Further, the unexpected volatility in interest rates due to external impulses should be reduced, and that in exchange rates increased, relative to a fixed exchange rate regime.
This study analyses the question of interest rate and exchange rate volatility before and after the floating of the Australian dollar in December 1983. The paper adopts an atheoretical methodology of vector autoregressions (VAR's) to calculate the forecast-error variance for interest rates and exchange rates (at different horizons) and to decompose these forecast-error variances into those parts attributable to domestic and external sources. A VAR model is estimated for both the pre- and post-float periods, on daily data for the Australian trade-weighted index, the Australian 90 day bank accepted bill rate, the US trade-weighted index, the US 90 day prime bankers' acceptances rate, the DM trade-weighted index, the West German 90 day interbank deposits rate, the Japanese trade-weighted index and the Japanese 90 day Gensaki rate. This is the minimum configuration that can capture both domestic and foreign sources of volatility in financial prices. The analysis supports the hypothesis that interest rates have become relatively less volatile (and the exchange rate relatively more volatile) with the move to a floating exchange rate regime. However, the evidence suggests that this has been due to a change in the nature of the relationship between the Autralian interest rate and exchange rate; rather than a shift in the incidence of external shocks. This supports the notion that a more independent monetary policy is possible under a floating exchange rate regime.