Exchange Rates and Interest Rates: Some Papers

Pablo Cuba Borda, Federal Reserve Board
Martin Bodenstein, Federal Reserve Board
Nils Gornemann, Federal Reserve Board
Ignacio Presno, Federal Reserve Board

We propose a model of international financial linkages that links exchange rate movements to changes in the demand for domestically produced goods compared to the demand for imported goods (trade rebalancing). Our model is consistent with the stylized facts of the exchange rate, including those related to the trade balance, which are often neglected in the literature on exchange rate determination. In quantitative analysis, trade rebalancing explains about 50 percent of exchange rate volatility during the business cycle, while external deviations from the undisclosed interest rate equilibrium—the main source of exchange rate volatility in the text—just over 20 percent. Using data on trade flows or trade balances is key to correctly targeting exchange rate decisions. Thus, our model overcomes the sharp dichotomy between the real exchange rate and macroeconomics embedded in other models of exchange rate determination.

Narrator:
Federica Romei, University of Oxford

Tarek Alexander Hassan, Boston University and NBER
Thomas Mertens, Federal Reserve Bank of San Francisco
Jingye Wang, Renmin University of China

Long-run risk models and trends combine high equity premia with smooth risk-free rates by creating an inverse functional relationship between the variance and the mean of the stochastic discount factor. We show this highly successful solution to asset pricing problems in closed economies is highly problematic when applied to open economies with perfect markets: It requires that the difference in capital returns arise almost exclusively from predicted appreciation, not from interest rate differences. In data, in contrast, exchange rates are unpredictable, and returns vary because interest rates vary widely across currencies. We show currency risk premia from canonical long-term risk and popular trends cannot match this reality. We argue this discrepancy between official asset pricing and international macroeconomic models is the main reason researchers have struggled to reconcile the observed behavior of exchange rates, interest rates, and international capital flows. The lack of such an integration model is a major obstacle to understanding the impact of risk on international markets.

Narrator:
Hanno Lustig, Stanford University and NBER

Seunghoon Na, Purdue University
Yinxi Xie, Bank of Canada

This paper investigates exchange rate volatility and its forecast errors by integrating quantitative insights into a small open model of the New Keynesian economy. Decision makers have limited foresight, unable to plan up to a limited distance into the future. This reveals the variable deviation of the forecast errors from the actual exchange rate at different time points. It also distinguishes between the formation of short-term and long-term expectations, where the Law of Multiple Expectations is violated. This framework provides a minimal basis for understanding time variation and horizon forecasting in uncovered interest parity (UIP) puzzles. Our model predictions for this UIP violation agree both qualitatively and quantitatively with the measurements used.

Narrator:
Rosen Valchev, Boston College and NBER

I found this paper particularly interesting as I, along with Guy Meredith, have found relationships consistent with this model. In Chinn and Meredith (1998).

Figure 2: A panel of beta coefficients at different locations. Notes: up to 12 months, 6 currency panel rates against US$, euro deposit rates, 1980Q1-2000Q4; The 3-year results are zero coupon yields, 1976Q1-1999Q2; 5- and 10-year, constant yield to maturity, 1980Q1-2000Q4 and 1983Q1-2000Q4 (the latter view is consistent with exchange rate data). Source: Chinn (2006).

Some updated results are in this post for 2022.