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A Macro-Finance Approach to Exchange Rate Determination

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  • Yu-chin Chen

    (University of Washington)

  • Kwok Ping Tsang

    (Virginia Tech)

Abstract

The nominal exchange rate is both a macroeconomic variable equilibrating international markets and a financial asset that embodies expectations and prices risks associated with cross border currency holdings. Recognizing this, we adopt a joint macro-finance strategy to model the exchange rate. We incorporate into a monetary exchange rate model macroeconomic stabilization through Taylor-rule monetary policy on one hand, and on the other, market expectations and perceived risks embodied in the cross-country yield curves. Using monthly data between 1985 and 2005 for Canada, Japan, the UK and the US, we employ a state-space system to model the relative yield curves between country-pairs using the Nelson and Siegel (1987) latent factors, and combine them with monetary policy targets (output gap and inflation) into a vector autoregression (VAR) for bilateral exchange rate changes. We find strong evidence that both the financial and macro variables are important for explaining exchange rate dynamics and excess currency returns, especially for the yen and the pound rates relative to the dollar. Moreover, by decomposing the yield curves into expected future yields and bond market term premiums, we show that both expectations about future macroeconomic conditions and perceived risks are priced into the currencies. These findings provide support for the view that the nominal exchange rate is determined by both macroeconomic as well as financial forces.

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Bibliographic Info

Paper provided by University of Washington, Department of Economics in its series Working Papers with number UWEC-2009-24-R.

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Date of creation: Dec 2009
Date of revision: May 2010
Handle: RePEc:udb:wpaper:uwec-2009-24-r

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Cited by:
  1. Yu-chin Chen & Kwok Ping Tsang & Wen Jen Tsay, 2010. "Home Bias in Currency Forecasts," Working Papers 272010, Hong Kong Institute for Monetary Research.
  2. Virtue Ekhosuehi & Sunday Ogbonmwan, 2014. "Determination of the optimal exchange rate via control of the domestic interest rate in Nigeria," Operations Research and Decisions, Wroclaw University of Technology, Institute of Organization and Management, vol. 1, pages 23-36.
  3. Anella Munro, 2014. "Exchange rates, expected returns and risk," Reserve Bank of New Zealand Discussion Paper Series DP2014/01, Reserve Bank of New Zealand.

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