This website uses cookies.

By clicking the "Accept" button or continuing to browse our site, you agree to first-party and session-only cookies being stored on your device to enhance site navigation and analyze site performance and traffic. For more information on our use of cookies, please see our Privacy Policy.

  1. Home
  2. ASSA Annual Meeting
  3. 2025
  4. Program
  5. Exchange Rate Premia: Drivers and Policy Implications
« Back to Results

Exchange Rate Premia: Drivers and Policy Implications

Paper Session

Sunday, Jan. 5, 2025 1:00 PM - 3:00 PM (PST)

Hilton San Francisco Union Square, Yosemite C
Hosted By: American Economic Association
  • Chair: Thuy Lan Nguyen, Federal Reserve Bank of San Francisco

Exchange Rate Models are Better than You Think, and Why They Didn't Work in the Old Days

Steve Pak Yeung Wu
,
University of California-San Diego
Charles Engel
,
University of Wisconsin-Madison

Abstract

Empirical exchange-rate models fit very well for the U.S. dollar in the 21st century. A “standard”
model that includes real interest rates and a measure of expected inflation for the U.S. and the
foreign country, the U.S. comprehensive trade balance, and measures of global risk and liquidity
demand is well-supported in the data. In the 1970s–1990s, the fit of the model was poor but it has
increased for both monetary and non-monetary variables almost monotonically to the present day. We provide evidence that better monetary policy has led to the improvement, as the scope for self-
fulfilling expectations have disappeared.

Foreign Exchange Intervention with UIP and CIP Deviations

Philippe Bacchetta
,
University of Lausanne
Kenza Benhima
,
University of Lausanne
Brendan Berthold
,
University of Lausanne

Abstract

We examine the opportunity cost of foreign exchange (FX) intervention when both CIP and UIP deviations are present. We consider a small open economy that receives international capital flows through constrained international financial intermediaries. Deviations from CIP come from limited arbitrage or through a convenience yield, while UIP deviations are also affected by risk. We show that the sign of CIP and UIP deviations may differ for safe haven countries. We examine the optimal policy of a constrained central bank planner in this context. We find that there may be a benefit, rather than a cost, of FX reserves if international intermediaries value more the safe haven properties of a currency than domestic households. We show that this has been the case for the Swiss franc and the Japanese Yen.

International Spillovers of Exchange Rate Policy

Dmitry Mukhin
,
London School of Economics
Oleg Itskhoki
,
University of California-Los Angeles

Abstract

We develop a general policy analysis framework for an open economy that features nominal rigidities and financial frictions giving rise to endogenous PPP and UIP deviations. The efficient allocation can be implemented with monetary policy closing the output gap and FX interventions eliminating UIP deviations. When the “natural” real exchange rate is stable, both goals can be achieved solely by monetary policy that fixes the exchange rate — an open-economy divine coincidence. More generally, optimal policy features a managed float/crawling peg complemented with FX forward guidance and macroprudential accumulation of FX reserves, in line with the “fear of floating” observed in the data. Capital controls are not necessary to achieve the frictionless allocation, but they facilitate the extraction of rents in the currency market. Constrained unilateral policies are not optimal from the global perspective, and international cooperation features a complementary use of FX interventions across countries.

Dealer Risk Limits and Currency Returns

Falk Braeuning
,
Federal Reserve Bank of Boston
Omar Barbiero
,
Federal Reserve Bank of Boston
Gustavo Joaquim
,
Amazon
Hilary Stein
,
Federal Reserve Bank of Boston

Abstract

We leverage supervisory micro data to uncover the role of global banks’ risk limits in driving exchange rate dynamics. Consistent with a model of currency intermediation under risk constraints, shocks to dealers’ risk limits lead to price and quantity adjustment in the foreign exchange market. We show that dealers adjust their net exposure and increase spread in response to granularly identified limit shocks, leading to lower turnover and an adjustment in currency returns. These shocks exacerbate effects of net currency demand on exchange rate movements, as predicted by theory, and trigger deviations from covered and uncovered interest parity

CIP Deviations in Emerging Markets: Drivers and Policies

Mai Chi Dao
,
International Monetary Fund
Pierre-Olivier Gourinchas
,
International Monetary Fund

Abstract

This paper studies the behavior of Covered Interest Parity (CIP) deviations (the CIP basis) in Emerging Markets (EM). Unlike Advanced Economies (AE), a major challenge for EMs is to measure local currency interest rates, free of credit risk. To do so, we construct the CIP basis for eight major EM currencies using supranational bonds issued in multiple currencies. By extracting the risk-free local currency interest rate, we obtain a measure of “purified" CIP basis for these currencies going back twenty years. We show that the “purified" CIP basis conforms with model-implied predictions for cross-sectional and within-country correlation of the basis with fundamental forces driving supply and demand for USD forwards. Policies that impact global Dollar funding, banks’ liquidity holding costs, or capital flows all interact with underlying USD hedging and funding needs, moving the CIP deviation in EM’s as predicted by the model.

Discussant(s)
Sebnem Kalemli-Ozcan
,
University of Maryland
Lorena Keller
,
University of Pennsylvania
Nikhil Patel
,
International Monetary Fund
Serra Pelin
,
University of California-Berkeley
Valentina Bruno
,
American University
JEL Classifications
  • F3 - International Finance
  • F4 - Macroeconomic Aspects of International Trade and Finance