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Connecting Exchange Rates to Fundamentals Under Indeterminacy

Author

Listed:
  • Ippei Fujiwara

    (Keio University)

  • Yasuo Hirose

    (Keio University)

Abstract

This paper establishes the connection of exchange rates to macroeconomic fundamentals by estimating a small open-economy model for Canada. The model incorporates an endogenous interest rate spread on foreign bond holdings, enabling the modified uncovered interest rate parity (UIP) condition to exhibit a negative relationship between expected exchange rate depreciation and interest rate differentials, as observed in the data. Given the model's susceptibility to equilibrium indeterminacy, we estimate it using Bayesian methods that allow for both determinacy and indeterminacy of equilibrium. The results reveal that preference shocks to the household utility function are the primary drivers of exchange rate fluctuations, highlighting the connection between exchange rates and macroeconomic fundamentals. We further demonstrate that both allowing for indeterminacy and selecting a specific equilibrium representation from the data are essential for achieving this finding.

Suggested Citation

  • Ippei Fujiwara & Yasuo Hirose, 2024. "Connecting Exchange Rates to Fundamentals Under Indeterminacy," Keio-IES Discussion Paper Series 2024-024, Institute for Economics Studies, Keio University.
    • Handle: RePEc:keo:dpaper:2024-024
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    References listed on IDEAS

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    Keywords

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    JEL classification:

    • C62 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Existence and Stability Conditions of Equilibrium
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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