We extend the literature on regime-dependent volatility in two ways. First, our microstructural model provides a qualitatively new explanation. Second, we test implications of our model using Europe's recent shift to rigidly fixed rates (EMS to EMU). In the model, shocks to order flow induce more volatility under flexible rates because the elasticity of speculative demand is (endogenously) low, leading to pronounced portfolio-balance effects. New data on FF/DM transactions show that order flow had persistent effects on the exchange rate before EMU parities were announced. After announcement, the FF/DM rate was decoupled from order flow, as the model predicts.
ASJC Scopus subject areas
- Economics and Econometrics