Dynamics of Exchange Rates and Capital Flows

We explore the quantitative implications of a framework where exchange rates are directly affected by financiers' risk bearing capacity and capital flows. Capital flows drive exchange rates by altering the balance sheets of financiers that bear the risks resulting from international imbalances in the demand for financial assets. Such alterations to their balance sheets cause financiers to change their required compensation for holding currency risk, thus impacting both the level and volatility of exchange rates. We calibrate the model show that it can account for the variability and correlation not only of financial variables, such as the exchange rate and capital flows, but also real variables, such as exports imports and consumption. The model can account for the "excess volatility" of the exchange rate, Backus and Smith puzzle, the failure of UIP, and the exchange rate disconnect. We also consider how policy interventions (especially interventions in the FX market) can mitigate the excess volatility and increase welfare.