Exchange Rate Volatility in an Equilibrium Asset Pricing Model

This paper analyzes a stochastic model of exchange rate determination with unrestricted access to capital and currency markets. It is shown that the only restriction imposed by the model on the equilibrium exchange rate is that it satisfy a martingale property. This implies that, for a given real equilibrium allocation (which is optimal), the model can display varying amounts of exchange rate volatility, and that volatility is unrelated to the welfare properties of the equilibrium allocation. Whether or not volatility is "excessive" therefore depends on which equilibrium is chosen as the basis for comparison.