A Macro-Finance Approach to Exchange Rate Determination

Abstract

The nominal exchange rate is both a macroeconomic variable equilibrating international markets and a …nancial asset that embodies expectations and prices risks associated with 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 employ a state-space system to model 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 in‡ation) 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. Moreover, by decomposing the yield curves into expected future yields and bond market term premiums, we show that both expectations about future macroeconomic conditions 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.