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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. Geert Bekaert & Seonghoon Cho & Antonio Moreno, 2005. "New-Keynesian Macroeconomics and the Term Structure," NBER Working Papers 11340, National Bureau of Economic Research, Inc.
    2. Richard Clarida & Jordi Gali & Mark Gertler, 1998. "Monetary policy rules in practice," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
    3. Ravn, Morten O. & Uhlig, Harald, 2001. "On Adjusting the HP-Filter for the Frequency of Observations," CEPR Discussion Papers 2858, C.E.P.R. Discussion Papers.
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    5. Christopher G. Lamoureux & H. Douglas Witte, 2002. "Empirical Analysis of the Yield Curve: The Information in the Data Viewed through the Window of Cox, Ingersoll, and Ross," Journal of Finance, American Finance Association, vol. 57(3), pages 1479-1520, 06.
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    7. Nelson C. Mark, 2009. "Changing Monetary Policy Rules, Learning, and Real Exchange Rate Dynamics," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(6), pages 1047-1070, 09.
    8. 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.
    9. 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.
    10. Potter, Simon M., 2000. "Nonlinear impulse response functions," Journal of Economic Dynamics and Control, Elsevier, vol. 24(10), pages 1425-1446, September.
    11. 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.
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