A structural investigation of third-currency shocks to bilateral exchange rates

Martin Melecký

MPRA Paper from University Library of Munich, Germany

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. Since positive US demand shocks have a greater positive impact on Japanese interest rates than on eurozone rates, the yen appreciates against the euro in response. Using quarterly data on the U.S., 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 setup, 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.

Keywords: bilateral exchange rates; third-currency shocks; New Keynesian policy model; three-country system; US dollar; euro; Japanese yen (search for similar items in EconPapers)
JEL-codes: F31 F36 F41 (search for similar items in EconPapers)
Date: 2007-10
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
https://mpra.ub.uni-muenchen.de/7402/2/MPRA_paper_7402.pdf original version (application/pdf)
https://mpra.ub.uni-muenchen.de/7632/1/MPRA_paper_7632.pdf revised version (application/pdf)

Related works:
Journal Article: A Structural Investigation of Third‐Currency Shocks to Bilateral Exchange Rates (2008)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:pra:mprapa:7402

Access Statistics for this paper

More papers in MPRA Paper from University Library of Munich, Germany Ludwigstraße 33, D-80539 Munich, Germany. Contact information at EDIRC.
Bibliographic data for series maintained by Joachim Winter ().