Third-Country Effects on the Exchange Rate

Nelson Mark and Kimberly Berg

No 1050, 2013 Meeting Papers from Society for Economic Dynamics

Abstract: This paper attributes the exchange-rate disconnect puzzle, which we characterize as the low adjusted R-squared in short-horizon predictive regressions, to omitted `third-country' variables. Using a three-country DSGE exchange rate model, we identify channels through which shocks originating in Country 3 can generate substantial variability in the bilateral exchange rate between Countries 1 and 2. In Monte Carlo experiments, using the model as the data generating process, we find that including Country 3 variables in otherwise conventional two-country exchange-rate regressions result in sizable increases in explanatory power. Empirical analysis of data from the U.S. and eleven other countries support the predictions of the theory.

Date: 2013
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Journal Article: Third-country effects on the exchange rate (2015)
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