 A Structural Investigation of Third‐Currency Shocks to Bilateral Exchange RatesInternational Finance, 2008, vol. 11, issue 1, 19-48 Abstract: An exchange rate between two currencies can be materially affected by shocks emerging from a third country. A US demand shock, for example, can affect the exchange rate between the euro and the yen. Because positive US demand shocks have a greater positive impact on Japanese interest rates than on euro area rates, the yen appreciates against the euro in response. Using quarterly data on the United States, the euro area and Japan from 1981 to 2006, this paper shows that the third‐currency effects are significant even when exchange rates evolve according to uncovered interest parity. This is because interest rates are typically set in response to output and inflation, which are in turn influenced by other exchange rates. More importantly, third‐currency effects are also transmitted to the actual exchange rate through the expected future exchange rate, which is, in a multi‐country set‐up, influenced by third‐countries' fundamentals and shocks. Third‐currency effects have a stronger impact on the currency of a relatively more open economy. The analysis implies that small open economies should avoid strict forms of bilateral exchange rate targeting, since higher trade and financial openness work as a force intrinsically amplifying currency fluctuations. Date: 2008 Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:bla:intfin:v:11:y:2008:i:1:p:19-48 Ordering information: This journal article can be ordered from Access Statistics for this article International Finance is currently edited by Benn Steil More articles in International Finance from Wiley Blackwell |
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