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Monetary Policy Rules and Exchange Rates:A Structural VAR Identified by No Arbitrage

  • Sen Dong


    (Finance and Ecnomomics Department Columbia University)

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    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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    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
    Date of revision:
    Handle: RePEc:red:sed006:875
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    Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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