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Monetary Policy Rules and Exchange Rates:A Structural VAR Identified by No Arbitrage

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  • Sen Dong

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    (Finance and Ecnomomics Department Columbia University)

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    Abstract

    Expected exchange rate changes are determined by interest rate differentials across countries and risk premia, while unexpected changes are driven by innovations to macroeconomic variables, which are amplified by time-varying market prices of risk. In a model where short rates respond to the output gap and inflation in each country, I identify macro and monetary policy risk premia by specifying no-arbitrage dynamics of each country's term structure of interest rates and the exchange rate. Estimating the model with US/German data, I find that the correlation between the model-implied exchange rate changes and the data is over 60%. The model implies a countercyclical foreign exchange risk premium with macro risk premia playing an important role in matching the deviations from Uncovered Interest Rate Parity. I find that the output gap and inflation drive about 70% of the variance of forecasting the conditional mean of exchange rate changes

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    File URL: http://repec.org/sed2006/up.28351.1140064130.pdf
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    Bibliographic Info

    Paper provided by Society for Economic Dynamics in its series 2006 Meeting Papers with number 875.

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    Date of creation: 03 Dec 2006
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    Handle: RePEc:red:sed006:875

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    Keywords: exchange rate; monetary policy; term structure; no arbitrage;

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    1. Andrew Ang & Sen Dong, 2005. "No-Arbitrage Taylor Rules," 2005 Meeting Papers 22, Society for Economic Dynamics.
    2. Richard Clarida & Jordi Gali & Mark Gertler, 1998. "Monetary policy rules in practice," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
    3. Bekaert, Geert & Cho, Seonghoon & Moreno, Antonio, 2006. "New-Keynesian Macroeconomics and the Term Structure," CEPR Discussion Papers 5956, C.E.P.R. Discussion Papers.
    4. Morten O. Ravn & Harald Uhlig, 2001. "On Adjusting the HP-Filter for the Frequency of Observations," CESifo Working Paper Series 479, CESifo Group Munich.
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    6. Nelson C. Mark, 2005. "Changing Monetary Policy Rules, Learning, and Real Exchange Rate Dynamics," NBER Working Papers 11061, National Bureau of Economic Research, Inc.
    7. Simon M. Potter, 1999. "Nonlinear impulse response functions," Staff Reports 65, Federal Reserve Bank of New York.
    8. Hans DEWACHTER & Konstantijn MAES, 2001. "An Affine Model for International Bond Markets," Center for Economic Studies - Discussion papers ces0106, Katholieke Universiteit Leuven, Centrum voor Economische Studiën.
    9. Jacquier, Eric & Polson, Nicholas G & Rossi, Peter E, 1994. "Bayesian Analysis of Stochastic Volatility Models," Journal of Business & Economic Statistics, American Statistical Association, vol. 12(4), pages 371-89, October.
    10. Anderson, Bing & Hammond, Peter J. & Ramezani, Cyrus A., 2010. "Affine Models of the Joint Dynamics of Exchange Rates and Interest Rates," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 45(05), pages 1341-1365, October.
    11. Amin, Kaushik I. & Jarrow, Robert A., 1991. "Pricing foreign currency options under stochastic interest rates," Journal of International Money and Finance, Elsevier, vol. 10(3), pages 310-329, September.
    12. Jacquier, Eric & Polson, Nicholas G & Rossi, Peter E, 1994. "Bayesian Analysis of Stochastic Volatility Models: Comments: Reply," Journal of Business & Economic Statistics, American Statistical Association, vol. 12(4), pages 413-17, October.
    13. Menzie D. Chinn & Guy Meredith, 2005. "Testing Uncovered Interest Parity at Short and Long Horizons during the Post-Bretton Woods Era," NBER Working Papers 11077, National Bureau of Economic Research, Inc.
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