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Trend Fundamentals and Exchange Rate Dynamics

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Abstract

We estimate a multivariate unobserved components-stochastic volatility model to explain the dynamics of a panel of six exchange rates against the US Dollar. The empirical model is based on the assumption that both countries' monetary policy strategies may be well described by Taylor rules with a time-varying inflation target, a time-varying natural rate of unemployment, and interest rate smoothing. The estimates closely track major movements along with important time-series properties of the real and nominal exchange rates across all currencies considered. The model generally outperforms a simple benchmark model that does not account for changes in trend inflation and trend unemployment.

Suggested Citation

  • Florian Huber & Daniel Kaufmann, 2015. "Trend Fundamentals and Exchange Rate Dynamics," KOF Working papers 15-393, KOF Swiss Economic Institute, ETH Zurich.
  • Handle: RePEc:kof:wpskof:15-393
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    File URL: http://dx.doi.org/10.3929/ethz-a-010513063
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    References listed on IDEAS

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    1. Charles Engel & Kenneth D. West, 2005. "Exchange Rates and Fundamentals," Journal of Political Economy, University of Chicago Press, vol. 113(3), pages 485-517, June.
    2. Gregor Bäurle & Daniel Kaufmann, 2014. "Exchange rate and price dynamics in a small open economy - the role of the zero lower bound and monetary policy regimes," Working Papers 2014-10, Swiss National Bank.
    3. 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, September.
    4. Barbara Rossi, 2013. "Exchange Rate Predictability," Journal of Economic Literature, American Economic Association, vol. 51(4), pages 1063-1119, December.
    5. Frühwirth-Schnatter, Sylvia & Wagner, Helga, 2010. "Stochastic model specification search for Gaussian and partial non-Gaussian state space models," Journal of Econometrics, Elsevier, vol. 154(1), pages 85-100, January.
    6. Giannoni, Marc P., 2014. "Optimal interest-rate rules and inflation stabilization versus price-level stabilization," Journal of Economic Dynamics and Control, Elsevier, vol. 41(C), pages 110-129.
    7. Olivier Coibion & Yuriy Gorodnichenko, 2012. "Why Are Target Interest Rate Changes So Persistent?," American Economic Journal: Macroeconomics, American Economic Association, vol. 4(4), pages 126-162, October.
    8. Timothy Cogley & Giorgio E. Primiceri & Thomas J. Sargent, 2010. "Inflation-Gap Persistence in the US," American Economic Journal: Macroeconomics, American Economic Association, vol. 2(1), pages 43-69, January.
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    13. Andrea Stella & James H. Stock, 2012. "A state-dependent model for inflation forecasting," International Finance Discussion Papers 1062, Board of Governors of the Federal Reserve System (U.S.).
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    More about this item

    Keywords

    Exchange rate models; Trend inflation; Natural rate of unemployment; Taylor rule; Unobserved components-stochastic volatility model;

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • C5 - Mathematical and Quantitative Methods - - Econometric Modeling
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation

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