A Note on Volatility Tradeoffs in the European Exchange Rate Mechanism

Abstract The study empirically examined the tradeoffs between the volatility of the exchange rate target zones and the volatility of nominal interest rate differentials. While the adoption of exchange rate regimes has declined over the past decades, their utilization still endures. A notable example is the European exchange rate mechanism, which now serves as an intermediary stage for new member states on their path to Euro adoption. The revived literature on this topic underscores the need for empirical support for volatility tradeoffs. The longstanding exchange rate mechanism offers a good opportunity for empirically testing these tradeoffs. The results using pooled regression on data drawn primarily from Bloomberg Terminal, covering 1984 to 2022 and including from various countries that participated in the exchange rate mechanism over the course of recent decades, confirm the results of some theoretical studies. Specifically, a policy seeking to narrow the exchange rate fluctuation margins leads to a decrease in the volatility of both the exchange rate and the interest rate differential.