Abstract
This paper shows that under absence of arbitrage opportunities the exchange rate reacts to restore equilibrium in international bond markets. The key factors determining its value are the difference between realized and implicit interest rate differentials, the underlying risk premium in bond markets and changes in market expectations on the long run exchange rate. The application of this model to the macroeconomy reveals the importance of the risk premium for setting monetary policy. We find that a relative increase/decrease in the risk premium between foreign and domestic debt markets increases/decreases the influence of foreign monetary policy for shifting real output.
Highlights
The exchange rate is an important macroeconomic instrument fundamental to analyze the relationship between macroeconomic variables such as interest rates, changes in money supply, real output, prices, or the balance of payments, across countries
Our theory on exchange rate determination has an immediate applicability to monetary policy
Our theoretical analysis of the short-run exchange rate highlights the importance of the difference between realized interest rate differentials in international bond markets and the differential predicted by the term structure of interest rates for each economy for determining the exchange rate in equilibrium
Summary
The exchange rate is an important macroeconomic instrument fundamental to analyze the relationship between macroeconomic variables such as interest rates, changes in money supply, real output, prices, or the balance of payments, across countries. The closest contributions to our paper are Obstfeld and Rogoff [3], that observe that the nominal exchange rate is an asset, and propose asset pricing models for exchange rate determination based on future market expectations; Engel and West [6] that study the forecasting ability of present value models and link them to macroeconomic fundamentals such as interest rates, money supply, real output or expected inflation; Engel, Mark and West [7] that present evidence that exchange rates are primarily determined by changes in expectations and show that these series incorporate news about future macroeconomic fundamentals; and Chen and Tsang [8] that discuss an empirical model for exchange rate determination based on macro-finance fundamentals In their model, the exchange rate is the result of the interactions between the risk premium on international bond markets and the foreign exchange market.
Sign-in/Register to view highlights & summary Sign-in/Register to access full text options 
Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a callDisclaimer: All third-party content on this website/platform is and will remain the property of their respective owners and is provided on "as is" basis without any warranties, express or implied. Use of third-party content does not indicate any affiliation, sponsorship with or endorsement by them. Any references to third-party content is to identify the corresponding services and shall be considered fair use under The CopyrightLaw.
