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By devising a real effective exchange rate (REER) index where bilateral exchange rates are weighted for relative trade shares, we find that the REER volatility (differently from the bilateral exchange rate volatility with the dollar) has significant impact on growth of per capita income after controlling for other variables traditionally considered in conditional convergence estimates. We also find that this (cost of volatility) effect can be reconciled with the concurring negative and significant effect on growth of the adoption of a fixed exchange rate regime (advantage of flexibility effect), where the latter may be also interpreted as the cost of choosing pegged regimes without harmonization of rules and macroeconomic policies with main trading partners. The adoption of an REER volatility measure, instead of a bilateral exchange rate with the dollar, has the advantage of making it possible a joint test for these two effects. This is because, while fixed exchange rate regimes are strongly negatively correlated, and almost collinear, with bilateral exchange rate volatility with the dollar, the correlation is much weaker when considering our REER volatility measure.

Two apparently opposite views in the literature exist when dealing with the effects of exchange rate regimes and volatility on growth. The first, that we define costs of volatility argument (CVA), establishes that exchange rate volatility may be harmful for growth and thus provides indirect support to the creation of monetary unions (also MUs) which eliminate part of this volatility (Buiter et al., 1998). According to this perspective, the elimination of exchange rate volatility among Union members ( Buiter et al., 1998 and Devereux et al., 2003) is generally considered a beneficial effect, given the perception that “unpredictable volatility can inflict damage” …[and that]… “Although the associated costs have not been quantified rigorously, many economists believe that exchange rate uncertainty reduces international trade, discourages investment and compounds the problems people face in insuring their human capital in incomplete asset markets.” (Obstfeld and Rogoff, 1995). On the same line, De Grauwe and Schnabl (2004) emphasise that, while Mundell (1961) theory of OCAs (which they term as Mundell I, following a classification proposed by McKinnon (2003)) suggests the well-known caveats to be considered before opting for a MU (minimum level of trade integration, limited occurrence of asymmetric shocks, sufficient mobility of workers), Mundell, 1973a and Mundell, 1973b (or Mundell II) provide quite different prescriptions. When exchange rate movements are an independent source of volatility and are also driven by speculative dynamics,1 anticipated entry into MUs may help small open economies to avoid negative macroeconomic effects of exchange rate volatility. De Grauwe and Schnabl (2004) empirical findings support this hypothesis finding a positive association between exchange rate stability and growth in Central and Eastern Europe for transition candidates in the last decade. The second view, which we define as advantage of flexibility argument (AFA), considers that terms of trade shocks are amplified in countries with more rigid exchange rate regimes and that, after controlling for other factors, countries with flexible exchange rate regimes grow faster (Edwards and Yeyati, 2003). This second approach traces back to Meade’s (1951) argument that, in countries with fixed exchange rates and inflexible money wages, adjustment in the equilibrium real exchange rates arising from external shocks will occur through domestic nominal prices and domestic wages. In such cases shock absorption would be easier under flexible exchange rate regimes. The same author recognizes that flexible exchange rates may not be of help in case of inflexible real wages, due to some indexation mechanisms. The advantage of flexibility effect also seems supported by empirical evidence. Edwards and Yeyati (2003) show that terms of trade shocks are amplified in countries with more rigid exchange rate regimes and that, after controlling for other factors, countries with flexible exchange rate regimes grow faster. Their result are consistent with those of Yeyati and Sturzenegger (2003a) also using de facto exchange rate classifications. The same finding disappears in empirical works in which de jure classifications are adopted (Gosh et al., 1996).2 An interpretation of these results is that it is not convenient to abandon flexibility and adopt fixed exchange regimes without harmonization of institutions and macroeconomic policies with main trading partners. This point is very well tackled by the existing literature when considering that, in absence of a common currency, exchange rate stability cannot coexist with divergences in fiscal and monetary policies (Giavazzi and Pagano, 1994 and Obstfeld and Rogoff, 1995). The point of our paper is that these apparently conflicting views (advantage of flexibility and cost of volatility) can be easily reconciled when exchange rate volatility is properly measured with a multilateral trade weighted exchange rate (real effective exchange rate or REER) and that the concurrence of both effects can be jointly tested in growth estimates. This is because, while the strong negative relationship between exchange rate flexibility and bilateral volatility with the dollar makes almost impossible that AFA and CVA may be jointly tested if volatility is measured with the latter, multilateral trade weighted exchange rate volatility is much less correlated with exchange rate regimes and allows to measure separately the two issues. By developing this intution the paper creates a framework for a joint test of the two hypotheses and is divided into four sections (including Sections 1 and 6). In Section 2, we provide a short survey of theoretical rationales and empirical findings on the relationship between exchange rate volatility and growth, focusing on the limits of the methodological approaches adopted to calculate exchange rate volatility. In Section 3, we propose our approach and explain methodology and rationales of our REER volatility indicator. In Section 4, we provide descriptive evidence on the dynamics of the REER volatility associated to measures of institutional quality and exchange rate regimes in different macroareas. In Sections 5, we present econometric findings and jointly test the two hypotheses of cost of volatility and advantage of flexibility.

The paper creates a framework where the impact on economic growth of two relevant effects of exchange rates on it identified by the literature (advantage of exchange rate flexibility and cost of exchange rate volatility) can be jointly taken into account. Our approach is based on the following point. When volatility is measured through bilateral exchange rate with the dollar, it is strongly negatively correlated with the adoption of fixed exchange rate regimes and the two arguments seem mutually exclusive. On the other hand, when volatility is considered in a broader and multilateral perspective, which includes also turbulences generated by trading partners, the negative link does not hold anymore and the two effects may be jointly tested. We therefore devise a comprehensive indicator of REER volatility which goes beyond the limits of bilateral exchange rate indicators. The paper finds that the real effective exchange rate risk variable performs much better than the bilateral exchange rate volatility with the dollar and has a significant negative effect on growth, which is robust to the inclusion of a dummy for fixed exchange rate regimes. These findings confirm the mutual existence of a cost of volatility and of an advantage of flexibility (or cost of choosing pegged regimes without harmonization of rules and macroeconomic policies with main trading partners) effect. The result is confirmed when the REERV variable is instrumented by proxies of the ex ante expected exchange rate volatility, such as measures of the relative quality of institutions and monetary policies vis á vis trading partners. Paper findings demonstrate that the REERV is not just a proxy for domestic governance and economic policies, but also a measure of how macroeconomic and institutional behaviour of trade partners affects country’s conditional convergence. Our approach creates an interesting framework to evaluate effects of policies such as those leading to the creation of monetary unions. One of the most debated questions in international economics is whether and in which way monetary unions may contribute to growth or, in other terms, which are the benefits that may compensate the costs of losing degrees of freedom (including the advantage of exchange rate flexibility) in managing domestic economic policies. Given that the main indisputable advantage of monetary unions is the reduction of exchange rate volatility with member trade partners, we find that this factor has positive and significant impact on growth. What growth estimates suggest in terms of convenience of different exchange rate regimes? Our results seem to find support for both the advantage of flexibility and the cost of volatility arguments documenting advantages of flexible exchange rate regimes, on the one side, and of monetary unions, on the other side, as a mean for drastically reducing REER volatility. In this perspective fixed exchange rate regimes seem not to share benefits of neither of the two previous situations, unless they are conceived as a transitory and credible signal of commitment for transition to a monetary union.