Macroeconomic fundamentals and the exchange rate dynamics: A no-arbitrage macro-finance approach |
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| Institution: | 1. International School of Economics and Management, Capital University of Economics and Business, Beijing 100070, China;2. ESSEC Business School, Paris, France; Singapore 188064, Singapore;1. Institute of Chinese Financial Studies, Southwestern University of Finance and Economics, No. 555, Liutai Avenue, Wenjiang District, Chengdu 611130, Sichuan, China;2. Hong Kong Institute for Monetary and Financial Research, One Pacific Place, No. 88 Queensway, Hong Kong, China;3. Center for Macroeconomic Research and Department of Finance at School of Economics, Wang Yanan Institute for Studies in Economics, Xiamen University, No. 422, Siming South Road, Xiamen 361005, Fujian, China;1. Department of Economics, Miami University, United States;2. Department of Economics, University of Notre Dame, United States;3. NBER, United States;1. Department of Economics, Miami University, United States;2. Department of Economics, University of Notre Dame and NBER, United States |
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| Abstract: | In this paper, we propose an arbitrage-free international macro-finance model that links the exchange rate dynamics to macroeconomic fundamentals. Jointly using data on exchange rates, yields of zero-coupon bonds, and macroeconomic variables of the US and the Euro area, we find a close link between macroeconomic fundamentals and the exchange rate dynamics. The model-implied monthly exchange rate changes can explain about 57% variation of the observed data. The macroeconomic innovations can help capture large variation of exchange rate changes. Robustness checks show that the results also hold for other major exchange rates. |
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| Keywords: | Exchange rate dynamics Macroeconomic fundamentals Stochastic discount factor Term structure of interest rates Unscented Kalman filter F31 G12 E43 C32 |
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