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A Macro-Finance Approach to Exchange Rate Determination* (2009)
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BibTeX
@MISC{Chen09amacro-finance,
author = {Yu-chin Chen and Kwok Ping Tsang},
title = {A Macro-Finance Approach to Exchange Rate Determination*},
year = {2009}
}
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Abstract
Abstract. The nominal exchange rate is both a macroeconomic variable equilibrating international mar-kets, and a nancial asset that embodies expectations and prices risks about cross border currency-holdings. Recognizing this, we adopt a joint macro- nance strategy to model the exchange rate. We incorporate into a monetary exchange rate model macroeconomic stabilization through Taylor-rule monetary policy on one hand, and on the other, market expectations and perceived risks embodied in the cross-country yield curves. Using monthly data between 1985 and 2005 for Canada, Japan, the UK and the US, we summarize infor-mation in the relative yield curves between country-pairs using the Nelson and Siegel (1987) latent factors, and combine them with monetary policy targets (output gap and ination) into a Vector Autoregression (VAR) for bilateral exchange rate changes. We nd strong evidence that both the nancial and macro variables are important for explaining exchange rate dynamics and excess currency returns, especially for the yen and the pound rates relative to the dollar. By decomposing the yield curves into expected future yields and bond market term premia, we show that both expectations and perceived risks are priced into the currencies. These ndings provide support for the view that the nominal exchange rate is determined by both macroeconomic as well as nancial forces..
Keyphrases
exchange rate determination macro-finance approach nominal exchange rate exchange rate dynamic taylor-rule monetary policy cross border currency-holdings strong evidence cross-country yield curve nancial asset monthly data relative yield curve market expectation price risk excess currency return future yield macroeconomic variable bond market term premia perceived risk pound rate latent factor vector autoregression exchange rate international mar-kets monetary policy target nancial force macro variable bilateral exchange rate change joint macro nance strategy output gap
