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A Fundamental Connection: Exchange Rates and Macroeconomic Expectations

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  • Stavrakeva, Vania
  • Tang, Jenny

Abstract

One of the most famous puzzles in international finance is the disconnect between exchange rates and macroeconomic fundamentals at business cycle frequencies. We disprove this puzzle by showing that the majority of variation in exchange rates at monthly and quarterly frequencies can be explained by macroeconomic news, which account for as much as 91 percent of the quarterly exchange rate variation during periods of US economic recessions and 64 percent over all periods. The main driver of the reconnect is exchange rates responding to past rather than contemporaneous news—a result inconsistent with the theory of uncovered interest rate parity (UIP). We discuss a number of theoretical models that can explain this surprising result. These include models featuring deviation from UIP due to the presence of currency risk premia, regulatory or institutional frictions, or models featuring deviation from full information rational expectations.

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  • Stavrakeva, Vania & Tang, Jenny, 2023. "A Fundamental Connection: Exchange Rates and Macroeconomic Expectations," CEPR Discussion Papers 18119, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:18119
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    Cited by:

    1. Ryan Chahrour & Vito Cormun & Pierre De Leo & Pablo Guerron-Quintana & Rosen Valchev, 2021. "Exchange Rate Disconnect Revisited," Boston College Working Papers in Economics 1041, Boston College Department of Economics, revised 12 May 2023.
    2. Emilian DOBRESCU, 2022. "Macroeconomic Measurement of Expectations versus Reality," Journal for Economic Forecasting, Institute for Economic Forecasting, vol. 0(3), pages 5-30, October.

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    More about this item

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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