A Macro-Finance Approach to Exchange Rate Determination

49 Pages Posted: 30 Jan 2011 Last revised: 20 Jul 2022

Multiple version iconThere are 2 versions of this paper

Date Written: January 27, 2011

Abstract

This working paper was written by Yu-chin Chen (University of Washington) and Kwok Ping Tsang (Virginia Tech).

The nominal exchange rate is both a macroeconomic variable equilibrating international markets and a financial asset that embodies expectations and prices risks associated with cross border currency holdings. Recognizing this, we adopt a joint macro-finance strategy to model the exchange rate. We incorporate into a monetary exchange rate model macroeconomic stabilization through Taylor-rule monetary policy on one hand, and on the other, market expectations and perceived risks embodied in the cross-country yield curves. Using monthly data between 1985 and 2005 for Canada, Japan, the UK and the US, we employ a state-space system to model the relative yield curves between country-pairs using the Nelson and Siegel (1987) latent factors, and combine them with monetary policy targets (output gap and inflation) into a vector autoregression (VAR) for bilateral exchange rate changes. We find strong evidence that both the financial and macro variables are important for explaining exchange rate dynamics and excess currency returns, especially for the yen and the pound rates relative to the dollar. Moreover, by decomposing the yield curves into expected future yields and bond market term premiums, we show that both expectations about future macroeconomic conditions and perceived risks are priced into the currencies. These findings provide support for the view that the nominal exchange rate is determined by both macroeconomic and financial forces.

Keywords: Exchange Rate, Term Structure, Latent Factors, Term Premiums

JEL Classification: E43, F31, G12, G15

Suggested Citation

Institute for Monetary and Financial Research, Hong Kong, A Macro-Finance Approach to Exchange Rate Determination (January 27, 2011). Hong Kong Institute for Monetary and Financial Research (HKIMR) Research Paper WP No. 01/2011, Available at SSRN: https://ssrn.com/abstract=1749351 or http://dx.doi.org/10.2139/ssrn.1749351

Hong Kong Institute for Monetary and Financial Research (Contact Author)

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