Abstract
Monetary policy has been introduced as a reaction function to macroeconomic variables to understand exchange rate dynamics. However, there has been no consensus on the implication of such endogenous monetary policy for exchange rate movements. This paper investigates this implication in a generalized Uncovered Interest Parity model. The model implies that the expectation of monetary policy is one of the channels for the macroeconomic fundamentals to in‡uence the exchange rate return. We obtain this expectation by modelling its formation process based on market survey forecasts of short-term interest rates. The analysis of the deutsche mark and euro relative to the U.S. dollar from 1979 to 2008 …nds that the expectation of monetary policy, which is determined by Taylor rule fundamentals, is able to capture the direction of change of exchange rate and forecast these changes. Moreover, modelling expectations based on survey forecast largely strengthens the role of the endogenous monetary policy.
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