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Exchange rate dynamics, expectations, and monetary policy

  • Chen, Qianying

This paper re-investigates the implications of monetary policy rules on changes in exchange rate, in a risk-adjusted, uncovered interest parity model with unrestricted parameters, emphasizing the importance of modeling market expectations of monetary policy. I use consensus forecasts as a proxy for market expectations. The analysis on the Deutsche mark, Canadian dollar, Japanese yen, and the British pound relative to the U.S. dollar from 1979 to 2008 shows that, through the expectations of future monetary policy, Taylor rule fundamentals are able to forecast changes in the exchange rate, even over short-term horizons of less than two years. Furthermore, the market expectation formation processes of short-term interest rates change over time and differ across countries, which contributes to the time varying relationship between exchange rates and macroeconomic fundamentals, together with the time varying currency risk premia and exchange rate forecast errors.

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Paper provided by Deutsche Bundesbank, Research Centre in its series Discussion Paper Series 1: Economic Studies with number 2011,18.

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Date of creation: 2011
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Handle: RePEc:zbw:bubdp1:201118
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  1. Flood, Robert P & Rose, Andrew K, 1994. "Fixes: Of the Forward Discount Puzzle," CEPR Discussion Papers 1090, C.E.P.R. Discussion Papers.
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  9. Richard H. Clarida & Daniel Waldman, 2008. "Is Bad News About Inflation Good News for the Exchange Rate? And, If So, Can That Tell Us Anything about the Conduct of Monetary Policy?," NBER Chapters, in: Asset Prices and Monetary Policy, pages 371-396 National Bureau of Economic Research, Inc.
  10. Molodtsova, Tanya & Papell, David H., 2009. "Out-of-sample exchange rate predictability with Taylor rule fundamentals," Journal of International Economics, Elsevier, vol. 77(2), pages 167-180, April.
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  15. Mahir Binici & Yin-Wong Cheung, 2011. "Exchange Rate Dynamics under Alternative Optimal Interest Rate Rules," Working Papers 1116, Research and Monetary Policy Department, Central Bank of the Republic of Turkey.
  16. Christian Wolff & Ron Jongen & Willem F.C. Verschoor, 2009. "Time-Variation in Term Permia: International Survey-Based Evidence," LSF Research Working Paper Series 09-02, Luxembourg School of Finance, University of Luxembourg.
  17. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
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  19. מחקר - ביטוח לאומי, 2007. "Annual Survey 2006," Working Papers 20, National Insurance Institute of Israel.
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