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

Sen Dong ()
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Sen Dong: Finance and Ecnomomics Department Columbia University

No 875, 2006 Meeting Papers from Society for Economic Dynamics

Abstract: 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

Keywords: exchange rate; monetary policy; term structure; no arbitrage (search for similar items in EconPapers)
JEL-codes: C13 E43 E52 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-ifn, nep-mac and nep-mon
Date: 2006-12-03

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