Exchange Rates and Interest Parity

Engel, Charles

doi:10.1016/b978-0-444-54314-1.00008-2

Cited by 182 publications

(142 citation statements)

References 198 publications

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“…More recently, Scholl and Uhlig (2008) recon…rm the result and …nd that the exchange rate peaks between 17 and 26 months after a monetary shock. These …ndings are in contrast to UIP predictions, and as such have proven di¢ cult to 1 explain (see Engel, 2013). Our approach to account for transaction services of treasuries leads to an endogenous liquidity premium that can contribute to explaining the observed exchange rate reactions to changes in interest rates di¤erentials.…”

Section: Introductioncontrasting

confidence: 48%

“…However, the empirical literature has shown that the UIP prediction fails not only conditional on monetary policy shocks, but also unconditionally. This is evidenced in the kind of empirical tests conducted by Fama (1984) and many others surveyed in Froot and Thaler (1992) and Engel (2013). The negative association between interest rate di¤erentials and depreciation rates seems to hold in general.…”

Section: Unconditional Correlationsmentioning

confidence: 75%

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Liquidity premia and interest rate parity

Linnemann

Schabert

2015

Journal of International Economics

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Risk-free assets denominated in US currency not only o¤er a pecuniary return, but also provide transactions services, both nationally and internationally. Accordingly, the responses of bilateral US dollar exchange rates to interest rate shocks should di¤er substantially with respect to the (US or foreign) origin of the shock. We demonstrate this empirically and apply a model of liquidity premia on US treasuries originating from monetary policy implementation. The liquidity premium leads to a modi…cation of uncovered interest rate parity (UIP), which is able to explain observed deviations of exchange rate dynamics from UIP predictions. In line with empirical evidence, the model predicts an appreciation of the US dollar subsequent to an increase in US interest rates as well as in SOE interest rates.JEL classi…cation: E4; F31; F41.

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Section: Introductioncontrasting

confidence: 48%

Section: Unconditional Correlationsmentioning

confidence: 75%

Liquidity premia and interest rate parity

Linnemann

Schabert

2015

Journal of International Economics

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“…Examining data on different currencies and spanning distinct sample periods, Sarno and Sojli (2009) and Balke et al (2013, hereafter BMW) identify a 1 Engel (2014) provides the most recent survey on past studies on nominal exchange rates. 2 Nominal exchange rates, therefore, need to Granger-cause future economic fundamentals, not vice versa.…”

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confidence: 99%

Exchange Rates and Fundamentals: Closing a Two-Country Model

Kano

2013

SSRN Journal

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In an influential paper, Engel and West (2005) claim that the near random-walk behavior of nominal exchange rates is an equilibrium outcome of a present-value model of a partial equilibrium asset approach when economic fundamentals follow exogenous first-order integrated processes and the discount factor approaches one. Subsequent empirical studies further confirm this proposition by estimating a discount factor that is close to one under distinct identification schemes. In this paper, I argue that the unit market discount factor implies the counterfactual joint equilibrium dynamics of random-walk exchange rates and economic fundamentals within a canonical, twocountry, incomplete market model. Bayesian posterior simulation exercises based on post-Bretton Woods data from Canada and the United States reveal difficulties in reconciling the equilibrium random-walk proposition within the two-country model; in particular, the market discount factor is identified as being much lower than one.

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“…An important step forward in this strand of research was that these models can be now brought to the data via the use of advanced estimation techniques (An and Schorfheide, 2007). From an econometric perspective, recent writings have also convincingly presented evidence that models estimated with large panels of data are able to outperform the RW in exchange rate forecasting (Engel, 2013;Ince, 2014). This suggests that the dismal forecasting performance of exchange rate models can be partly attributed to estimation rather than mis-specification error.…”

Section: Introductionmentioning

confidence: 99%

Exchange rate forecasting with DSGE models

Zorzi

Kolasa

Rubaszek

2017

Journal of International Economics

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Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may AbstractWe run a real exchange rate forecasting "horse race", which highlights that two principles hold. First, forecasts should not replicate the high volatility of exchange rates observed in sample. Second, models should exploit the mean reversion of the real exchange rate over long horizons. Abiding by these principles, an open-economy DSGE model performs well in real exchange rate forecasting. However, it fails to forecast nominal exchange rates better than the random walk. We find that the root cause is its inability to predict domestic and foreign inflation. This shortcoming leads us toward simpler ways to outperform the random walk. Non-technical summaryEconomic theory provides policymakers with clear guidance on how the competitiveness channel operates in the aftermath of a wide set of disturbances, such as monetary, productivity, risk premium or foreign shocks. However, there is a cloud hanging over this aspect of international economics, namely that these conjectures may have limited empirical significance, given the systematic failure of macro models to beat even the naïve random walk (RW) in exchange rate forecasting (the "exchange rate disconnect puzzle"). The question then naturally arises of whether international macro models are rich enough to be meaningful. Layers of complexity are typically added to improve their realism. For example, including in the features of the model the currency of trade invoicing may help the model to capture better the degree of exchange rate pass-through. Similarly, distinguishing the currency of denomination of asset and liabilities, may lead to a better description of the dynamics of external debt, which may be essential to better understand real exchange rate movements in emerging countries. On the other hand, imposing too many restrictions on the data generating process, either theoretically or in the estimation phase, may prove disadvantageous from a pure forecasting perspective given the higher number of estimated parameters. Every cloud has a silver lining, however. The exchange rate disconnect puzzle has spurred economists to look for new directions of research with success. Openeconomy dynamic stochastic general equilibrium (DSGE) models are clearly a major accomplishment from the theoretical perspective. The empirical literature has also shown why, by properly accounting for estimation error, exchange rate models may be better than we usually think. The consen...

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Exchange Rates and Interest Parity

Cited by 182 publications

References 198 publications

Liquidity premia and interest rate parity

Liquidity premia and interest rate parity

Exchange Rates and Fundamentals: Closing a Two-Country Model

Exchange rate forecasting with DSGE models

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