Soft Power and Exchange Rate Volatility

Standard models—based exclusively on macro-financial variables—have made little progressin explaining the behavior of exchange rates. In this paper, we introduce a neglected set of "softpower" factors capturing a country's demographic, institutional, political and socialunderpinnings to uncover the "missing" determinants of exchange rate volatility over time andacross countries. Based on a balanced panel dataset comprising 115 countries during the period1996–2011, the empirical results are generally robust across different estimation methodologiesand show a high degree of persistence in exchange rate volatility, especially in emerging marketeconomies. After controlling for standard macroeconomic factors, we find that the "soft power"variables—such as an index of voice and accountability, life expectancy, educationalattainment, the z-score of banks, and the share of agriculture relative to services—have astatistically significant influence on the level of exchange rate volatility across countries.