<p>What is the impact of heightened exchange rate volatility on business cycle dynamics? This question is particularly important for emerging economies where exchange rate volatility is substantially higher and time-varying. Using data from emerging countries, we show that exchange rate volatility is an important source of business cycle fluctuations. We find that heightened exchange rate volatility yields a drop in economic activity, an increase in prices, and an exchange rate depreciation. We rationalize our empirical findings in a small open economy New-Keynesian model augmented with time-varying volatility of exchange rate shocks. In the structural model, the main ingredient of the transmission mechanism is the households’ precautionary behavior. We also show that no other shocks, often featured in the literature, can produce the reported co-movement pattern among the macro variables.</p>