Exchange rate dynamics, expectations, and monetary policy
TL;DR: In this paper, a generalized uncovered interest parity model is proposed to model the formation process of the exchange rate based on market survey forecasts of short-term interest rates, and it is shown that the expectation of monetary policy, which is determined by Taylor rule fundamentals, is able to capture the direction of change of exchange rate and forecast these changes.
Abstract: Monetary policy has been introduced as a reaction function to macroeconomic variables to understand exchange rate dynamics. However, there has been no consensus on the implication of such endogenous monetary policy for exchange rate movements. This paper investigates this implication in a generalized Uncovered Interest Parity model. The model implies that the expectation of monetary policy is one of the channels for the macroeconomic fundamentals to in‡uence the exchange rate return. We obtain this expectation by modelling its formation process based on market survey forecasts of short-term interest rates. The analysis of the deutsche mark and euro relative to the U.S. dollar from 1979 to 2008 …nds that the expectation of monetary policy, which is determined by Taylor rule fundamentals, is able to capture the direction of change of exchange rate and forecast these changes. Moreover, modelling expectations based on survey forecast largely strengthens the role of the endogenous monetary policy.
Figures (24)
Figure 1: U.S. Short-term Interest Rate Forecast (Forecast Horizon=3 Months)-pre Euro Era 
Table 9: Comparison of correlation with Mark (2009) and Engel and West (2006) -Pre-euro Era 
Figure 3: 5-year Correlation between the Monetary Policy Component and Actual Exchange Rate Change over the previous 6 months 
Figure 13: German Short-term Interest Rate Forecast (Forecast Horizon=3 Months)-pre Euro Era 
Table 5: Statistical Properties of Short-term Interest Rates in Pre-euro Era 
Figure 4: 10-year Correlation between the Monetary Policy Component and Actual Exchange Rate Change over the previous 6 months 
Table 1: Ratio of the RMSE Relative to Driftless Ramdom Walk (Exchange Rate Change over 6-month Horizon ) 
Figure 8: Goodness of Fit of the Monetary Policy Component – GBP/USD 
Figure 7: Goodness of Fit of the Monetary Policy Component – JPY/USD 
Figure 12: Exchange rate change over half year, GBP/USD, actual, predicted 
Figure 15: 5-year Correlation between the Sum of Expected Short-term Interest Rate Differential and DM/USD changes over 6-month 
Figure 11: Exchange rate change over half year, JPN/USD, actual, predicted 
Figure 2: U.S. Short-term Interest Rate Forecast (Forecast Horizon=3 Months)-Euro Era 
Figure 6: Goodness of Fit of the Monetary Policy Component – CAD/USD 
Figure 14: German Short-term Interest Rate Forecast (Forecast Horizon=3 Months)-Euro Era 
Table 2: Comparison between the U.S. Interest Rate Forecast from Best-fit VAR and Consensus in Pre-euro Era 
Figure 10: Exchange rate change over half year, CAD/USD, actual, predicted 
Figure 10: Exchange rate change over half year, CAD/USD, actual, predicted 
Figure 16: 10-year Correlation between the Sum of Expected Short-term Interest Rate Differential and DM/USD changes over 6-month 
Table 10: Properties of Model Implied Exchange Rate Return with Market Participants' Expectation-Euro Era 
Figure 5: Goodness of Fit of the Monetary Policy Component – DM/USD
Citations
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Proceedings Article•
01 Jan 2005TL;DR: In this paper, the authors apply newly developed tests for nested model that are robust to the presence of parameter instability and find that for some countries we can reject the hypothesis that exchange rates are random walks.
Abstract: Many authors have documented that it is challenging to explain exchange rate fluctuations with macroeconomic fundamentals: a random walk forecasts future exchange rates better than existing macroeconomic models. This paper applies newly developed tests for nested model that are robust to the presence of parameter instability. The empirical evidence shows that for some countries we can reject the hypothesis that exchange rates are random walks. This raises the possibility that economic models were previously rejected not because the fundamentals are completely unrelated to exchange rate fluctuations, but because the relationship is unstable over time and, thus, difficult to capture by Granger Causality tests or by forecast comparisons. We also analyze forecasts that exploit the time variation in the parameters and find that, in some cases, they can improve over the random walk.
14 citations
TL;DR: This paper found that forecast inflation uncertainty strongly intensifies the reaction of the interest rate decisions to a forecast deviation of inflation from target, while forecast output growth uncertainty attenuates the reaction to a deviation of output growth from its long-run mean.
Abstract: To assess the Bank of England’s Monetary Policy Committee decisions on the official bank rate under forecast uncertainty, I estimate simple forecast-based interest rate rules augmented by the exact forecast standard deviations recovered directly from the Inflation Report fan charts. I find that forecast inflation uncertainty strongly intensifies the reaction of the interest rate decisions to a forecast deviation of inflation from target. Conversely, forecast output growth uncertainty attenuates the reaction of the interest rate decisions to a forecast deviation of output growth from its long-run mean. Asymmetries in forecast uncertainty are highly relevant for inflation. Forecast upward risks to inflation contribute strongly to the intensifying effect of forecast inflation uncertainty, while forecast downward risks have hardly any significant impact. Moreover, I find that forecast risks to inflation have a direct effect on the interest rate decisions, in particular when inflation is forecast close to target. Uncertainty forecasts obtained from the Survey of External Forecasters, though, contain no explanatory power.
11 citations
Posted Content•
TL;DR: In this article, an empirical cost of carry model with exogenously conditioned convenience yield was developed using monthly prices of all futures contracts traded at the New York Mercantile Exchange between 1985 and 2006.
Abstract: This paper develops an empirical cost of carry model with exogenously conditioned convenience yield. The approach is implemented using monthly prices of all futures contracts traded at the New York Mercantile Exchange between 1985 and 2006. Tests indicate that the model fits the data extremely well, much better than the unconditional model. Though the paper concentrates on oil, the approach can be used for any other commodity with well-developed futures markets. JEL: F3; G1; N2
References
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TL;DR: In this article, the authors examine how recent econometric policy evaluation research on monetary policy rules can be applied in a practical policymaking environment, and the discussion centers around a hypothetical but representative policy rule much like that advocated in recent research.
8,414 citations
"Exchange rate dynamics, expectation..." refers background in this paper
...Although empirical papers, including Taylor (1993) and Clarida et al (1998) show that the U.S. controlled their short-term rates following the Taylor rule at that time, the public could believe that a di¤erent rule was in e¤ect due to the fact that Taylor rule was not well known before early 1990s…...
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TL;DR: In this article, the authors estimate a forward-looking monetary policy reaction function for the postwar United States economy, before and after Volcker's appointment as Fed Chairman in 1979, and compare some of the implications of the estimated rules for the equilibrium properties of ineation and output, using a simple macroeconomic model.
Abstract: We estimate a forward-looking monetary policy reaction function for the postwar United States economy, before and after Volcker’s appointment as Fed Chairman in 1979. Our results point to substantial differences in the estimated rule across periods. In particular, interest rate policy in the Volcker-Greenspan period appears to have been much more sensitive to changes in expected ineation than in the pre-Volcker period. We then compare some of the implications of the estimated rules for the equilibrium properties of ineation and output, using a simple macroeconomic model, and show that the Volcker-Greenspan rule is stabilizing.
3,914 citations
TL;DR: This paper found that since 1979 each of the G3 central banks has pursued an implicit form of inflation targeting, which may account for the broad success of monetary policy in those countries over this time period.
2,227 citations
TL;DR: In this paper, the authors find that most of the variation in forward rates is variation in premium, and the premium and expected future spot rate components of forward rates are negatively correlated, and they conclude that the forward market is not efficient or rational.
2,217 citations
"Exchange rate dynamics, expectation..." refers background in this paper
...L ranges from 5 to 9Papers include Fama (1984), Flood and Rose (1996) etc. Lustig and Verdelhan (2007) propose explanation of the positive excess return in terms of consumption growth and risk hedging....
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Book•
01 Jan 2001
TL;DR: In this paper, the authors propose a statistical learning approach to predict the evolution of expectations and selection between alternative equilibria, with implications for business cycles, asset price volatility, and policy.
Abstract: A crucial challenge for economists is figuring out how people interpret the world and form expectations that will likely influence their economic activity. Inflation, asset prices, exchange rates, investment, and consumption are just some of the economic variables that are largely explained by expectations. Here George Evans and Seppo Honkapohja bring new explanatory power to a variety of expectation formation models by focusing on the learning factor. Whereas the rational expectations paradigm offers the prevailing method to determining expectations, it assumes very theoretical knowledge on the part of economic actors. Evans and Honkapohja contribute to a growing body of research positing that households and firms learn by making forecasts using observed data, updating their forecast rules over time in response to errors. This book is the first systematic development of the new statistical learning approach. Depending on the particular economic structure, the economy may converge to a standard rational-expectations or a "rational bubble" solution, or exhibit persistent learning dynamics. The learning approach also provides tools to assess the importance of new models with expectational indeterminacy, in which expectations are an independent cause of macroeconomic fluctuations. Moreover, learning dynamics provide a theory for the evolution of expectations and selection between alternative equilibria, with implications for business cycles, asset price volatility, and policy. This book provides an authoritative treatment of this emerging field, developing the analytical techniques in detail and using them to synthesize and extend existing research.
1,988 citations