1The Exchange Rate Policy of the Euro: A Matter of Size?*

Abstract: This paper analyses how country size affects exchange rate policy and volatility. A hump shaped relation between exchange rate variability and the size of countries is generated in the theoretical model: exchange rate variability increases with country size for small countries but then decreases for large countries. The paper finds that this theoretical prediction holds well for bilateral exchange rates of the OECD countries on the period between 1980 and 1995 as well as for a subsample of European exchange rates with respect to the dollar. The results suggest that the dollar/euro volability should be lower than the present dollar/DM volatility but that the decrease may depend significatively on the size and composition of EMU