Exchange Rates: Macroeconomic and Behavioral Drivers
Paper Session
Sunday, Jan. 3, 2021 3:45 PM - 5:45 PM (EST)
- Chair: Jenny Tang, Federal Reserve Bank of Boston
Asset Pricing with Mis-Specified Models
Abstract
We provide a framework to study the implications of model misspecification on asset prices.We consider an economy in which agents can only entertain models with at most k factors, where k may be distinct from the true number of factors that drive the economy’s fundamentals. We first characterize the implications of the resulting departure from rational expectations for return predictability at various horizons. We then apply our framework to two applications in asset pricing: (i) violation of uncovered interest rate parity at different horizons and (ii) momentum and reversal in equity returns. When applied to these contexts, our framework matches the reversal of violations of uncovered interest rate parity at longer horizons observed in the data and delivers short-run momentum as well as long-term reversal in equity returns.
Optimal Monetary and Exchange Rate Policies with Imperfect Financial Markets
Abstract
We study the optimal mix of monetary and macroprudential policies in a context of a small open economy in the presence of two frictions — nominal rigidities and imperfect international risk sharing. In contrast to the previous normative literature, we focus on segmented asset markets with noise traders and the stochastic discount factor of arbitrageurs endogenous to local policy. We show that the optimal policy uses monetary instruments for inflation targeting and FX interventions to offset demand shocks of noise traders and enhance international risk sharing. The free-floating exchange rates are optimal in this benchmark. This result, however, changes once additional constraints are imposed on macroprudential policy. On the one hand, lower volatility of exchange rates makes the carry trade less risky and hence, encourages arbitrageurs to absorb noise-trader shocks and improves the risk sharing. On the other hand, more volatile exchange rates increase the riskiness of the carry trade and discourage arbitrageurs from taking large positions against the central bank. The latter motive dominates when FX reserves are constrained to be non-negative and there is an asymmetric risk of exchange rate depreciation that stimulates speculations against the central bank.A Fundamental Connection: Exchange Rates and Macroeconomic Expectations
Abstract
This paper presents new stylized facts about exchange rates and their relationship with macroeconomic fundamentals. We show that macroeconomic surprises explain, on average, about 70 percent of variation in nominal exchange rate changes at quarterly frequency. Using a novel present value decomposition of exchange rate changes that is disciplined with survey forecast data, we further show that macroeconomic surprises are also a very important driver of the currency risk premia component and explain about 50 percent of its variation. These surprises have even greater explanatory power during periods of economic downturns and financial uncertainty.Discussant(s)
Hélène Rey
,
London Business School
Dimitri Vayanos
,
London School of Economics
Ludwig Straub
,
Harvard University
Domenico Giannone
,
Amazon
JEL Classifications
- F3 - International Finance
- F3 - International Finance