Are Exchange Rates Excessively Variable?

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Abstract
"Unnecessary variation" is defined as variation not attributable to variation in fundamentals. In the absence of a good model of macroeconomic fundamentals, the question "are exchange rates excessively variable?" cannot be answered by comparing the variance of the actual exchange rate to the variance of a set of fundamentals. This article notes the failure of regression equations to explain exchange rate movements even using contemporaneous macroeconomic variables, as well as the statistical rejections of the unbiasedness of the forward exchange rate as a predictor. It then argues that, given these results, there is not much to be learned from the variance-bounds tests and bubbles tests. The article then discusses recent results on variation in the exchange risk premiums arising from variation in conditional variances, both as a source of the bias in the forward rate tests and as a source of variation in the spot rate. It ends with a discussion of whether speculators' expectations are stabilizing or destabilizing, as measured by survey data. The conclusion is that it is possible that exchange rates have been excessively variable-as, for example, when there are speculative bubbles-but that if policy makers try systematically to exploit their credibility in order to stabilize exchange rates, they may see their current credibility vanish.

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