Medium-term macroeconomic determinants of exchange rate volatility

Is there a short- to medium-term linkage between macroeconomic and exchange rate volatility? This paper provides a clear-cut answer to the above question, pointing to significant linkages and trade-offs between macroeconomic and exchange rate volatility, particularly involving output volatility. Evidence of bidirectional causality is also found, with macroeconomic volatility showing a stronger causal power than exchange rate volatility. Many tasks in finance, such as option pricing, risk analysis, and portfolio allocation, rely on the availability of good forecasting models. The paper points to new directions for the construction of improved medium-term volatility models.