The dynamics of exchange rate volatility: A panel VAR approach

•The dynamics of exchange rate volatility is studied using a panel VAR model.•Spectral analysis is used to isolate the most destabilizing components of volatility.•Overall volatility and the high-frequency components show a similar and statistically significant response to the variables in the system.•The feedback effects are more pronounced for the developing countries.•The results are largely immune to several robustness checks.

This paper employs a panel vector autoregressive model (PVAR) to study the dynamics of the overall exchange rate volatility. PVAR estimation results, based on panel data for 29 economies, are used in simulating impulse response functions. Since economic shocks may affect high-frequency and low-frequency components of volatility differently, using a conventional time-domain approach to study volatility may lead to spurious results. Accordingly, the paper also studies the dynamics of the most destabilizing (high-frequency) components of exchange rate volatility, which are isolated using spectral methodology. While our investigation reveals interesting dynamic interrelationships between macroeconomic as well as financial variables and exchange rate volatility, we find little evidence of significant difference in the responses of macroeconomic and financial variables to the overall volatility vis-à-vis the high-frequency components thereof. The feedback effects from exchange rate volatility to macroeconomic and financial variables are found to be much stronger for developing countries relative to developed economies. These findings are confirmed by variance decompositions and are largely immune to several robustness checks.