Exchange models are the best fit for the US dollar in the 21st century. A “standard” model that includes real interest rates and expected US and foreign inflation, the US aggregate trade balance, and measures of global risk and capital demand is well supported in the US data versus others. G10 currencies. Monetary and non-monetary variables play an equally important role in explaining exchange rate movements. In the 1970s – early 1990s, model fit was poor but the fit (as measured by t- and F-statistics, and R-squareds) has increased almost uniformly until today. We make the case that better monetary policy (controlling inflation) has led to improvement, as the scope for self-fulfilling expectations has disappeared. We provide a variety of evidence linking changes in monetary policy to the performance of the exchange rate model.
That’s according to a new NBER working paper by Charles Engel and Steve PY Wu. How long will this last?
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