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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

    as
    1. Cosmin Ilut, 2012. "Ambiguity Aversion: Implications for the Uncovered Interest Rate Parity Puzzle," American Economic Journal: Macroeconomics, American Economic Association, vol. 4(3), pages 33-65, July.
    2. Justiniano, Alejandro & Preston, Bruce, 2010. "Can structural small open-economy models account for the influence of foreign disturbances?," Journal of International Economics, Elsevier, vol. 81(1), pages 61-74, May.
    3. Adrien Verdelhan, 2010. "A Habit‐Based Explanation of the Exchange Rate Risk Premium," Journal of Finance, American Finance Association, vol. 65(1), pages 123-146, February.
    4. Christiano, Lawrence J. & Trabandt, Mathias & Walentin, Karl, 2011. "Introducing financial frictions and unemployment into a small open economy model," Journal of Economic Dynamics and Control, Elsevier, vol. 35(12), pages 1999-2041.
    5. Frank Smets & Rafael Wouters, 2007. "Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach," American Economic Review, American Economic Association, vol. 97(3), pages 586-606, June.
    6. Ravi Bansal & Ivan Shaliastovich, 2013. "A Long-Run Risks Explanation of Predictability Puzzles in Bond and Currency Markets," The Review of Financial Studies, Society for Financial Studies, vol. 26(1), pages 1-33.
    7. Kim, Soyoung & Roubini, Nouriel, 2000. "Exchange rate anomalies in the industrial countries: A solution with a structural VAR approach," Journal of Monetary Economics, Elsevier, vol. 45(3), pages 561-586, June.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Exchange rate disconnect; UIP puzzle; Indeterminacy; Bayesian estimation;
    All these keywords.

    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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