ABSTRACT
The Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) adopted a target zone system in March 1979, because the flexible exchange rates were too volatile. Theoretically, real exchange rate volatility can have important effects on domestic and foreign investment decisions. A theoretical study by Aizenman showed that both domestic and foreign investments are higher in a fixed exchange rate system. There are few empirical studies about the effects of both real exchange rates and real exchange rate volatility on investment. The objective of this study is to test the effects of the levels and volatility of real exchange rates on investment in manufacturing sectors for open economies. Exchange rate management has implications for the behavior of interest rates. A reduction in real exchange rate volatility may cause real interest rate volatility to rise. In other words, volatility can be transferred from exchange rates to interest rates.
