Exchange Rate Determination
Friday, Jan. 4, 2019 8:00 AM - 10:00 AM
- Chair: Collin Rabe, University of Richmond
International Capital Flow Pressures
AbstractThis paper presents a new measure of capital flow pressures in the form of a recast Exchange Market Pressure index. The measure captures pressures that materialize in actual international capital flows as well as pressures that result in exchange rate adjustments. The formulation is theory-based, relying on balance of payments equilibrium conditions and international asset portfolio considerations. Based on the modified exchange market pressure
index, the paper also proposes the Global Risk Response Index, which reflects the country-specific sensitivity of capital flow pressures to measures of global risk aversion. For a large sample of countries over time, we demonstrate time variation in the effects of global risk on exchange market pressures, the evolving importance of the global factor across types of
countries, and the changing risk-on or risk-off status of currencies.
Intertemporal Substitution, Precautionary Saving, and Currency Premium
AbstractWhen the expected consumption growth depends positively on the consumption volatility, the interest rate will depend positively on the consumption volatility, due to the intertemporal substitution effect, and negatively on the square of the volatility (consumption variance), due to the precautionary saving effect. In a two-country model of such economies, the interest-rate spread is positively correlated with currency premium but negatively correlated with expected currency premium of long horizon. Thus, the Engel (2016) paradox is resolved with this model.
Volatility, Intermediaries, and Exchange Rates
AbstractThis paper studies how time-varying volatility drives exchange rates through financial intermediaries’ risk management. We propose a model where currency market participants are levered intermediaries subject to value-at-risk constraints. Higher volatility translates into tighter financial constraints. Therefore, intermediaries require higher returns to hold foreign assets, and the foreign currency is expected to appreciate. Estimated by the simulated method of moments, our model quantitatively resolves the Backus-Smith puzzle, the forward premium puzzle, the exchange rate volatility puzzle, and generate deviations from covered interest rate parity. Our empirical tests verify model implications that volatility and financial constraint tightness predict exchange rates.
Exchange Rate Disconnect: The Role of Trade Shocks
AbstractStandard macro models fail to explain why real exchange rates are volatile, and disconnected from aggregate real activity. This paper presents a simple two-country, Real Business Cycle model that can solve this puzzle. There are shocks to total factor productivity and ‘trade shocks’, modeled as exogenous shifts in a country’s local spending bias. These trade shocks capture, in a reduced form way, preference/technological shifts between domestic and imported goods and changes in trade costs/protectionism. Estimated trade shocks exhibits wide cyclical fluctuations that are weakly correlated across OECD countries.
The paper shows that trade shocks are a more powerful source of fluctuations in the real exchange rate and the trade balance than productivity shocks. A positive shock to a country’s local spending bias appreciates the country’s real exchange rate and boosts its output. By contrast, a positive productivity shock depreciates the real exchange rate (while also raising domestic output). A model with joint productivity shocks and trade shocks can generate a realistic correlation between real activity and the real exchange rate, i.e. a correlation that is close to zero. Trade shocks also help to explain the empirical volatility of the real exchange rate and the trade balance.
The paper considers a widely discussed alternative explanation for exchange rate volatility and exchange rate disconnect: shocks to the uncovered interest parity (UIP) condition,i.e. financial shocks (see, e.g., Kollmann, 2002; Itskhoki and Mukhin, 2018). Bayesian model estimates suggest that trade shocks are more important drivers of the real exchange rate and the trade balance than UIP shocks.
- F3 - International Finance