Exchange Rates: New Papers

During the summer, I had the good fortune to attend two excellent conferences focused on new findings in exchange rate economics (yes, not all economic research is focused on the financial crisis and recession). The first was a Bank of Canada-European Central Bank conference Exchange rates: The global perspective, and the second was the NBER International Finance and Macroeconomics Summer Institute session “Exchange Rates and Relative Prices”.


Figure 1: Log nominal value of US dollar (blue) and real value of US dollar (red), against currencies of major trading partners. NBER defined recession dates shaded gray, assuming the recession has not ended by July 2009. Source: Federal Reserve Board.

The Bank of Canada-ECB conference papers are here. All the papers, as well as powerpoint files of the presenters and discussants, are available from the conference website; I’ve reproduced some of the abstracts below.

Order flows and the exchange rate disconnect puzzle


M. Evans (Georgetown University)


Discussant: P. Vitale (G. D’Annunzio University)

This paper was also presented at the NBER conference — see below for the abstract and my discussion of the paper.

What does the yield curve tell us about exchange rate predictability?


Y. Chen (University of Washington), K. P. Tsang (Virginia Tech)


This paper uses information contained in the cross-country yield curves to test the asset pricing approach to exchange rate determination, which models the nominal exchange rate as the discounted present value of its expected future fundamentals. Since the term structure of interest rates embodies information about future economic activity such as GDP growth and inflation, we extract the Nelson-Siegel (1987) factors of relative level, slope, and curvature from cross-country yield differences to proxy expected movements in future exchange rate fundamentals. Using monthly data between 1985-2005 for the United Kingdom, Canada, Japan and the US, we show that the yield curve factors predict bilateral exchange rate movements and explain excess currency returns one month to two years ahead. They also outperform the random walk in forecasting short-term exchange rate returns out of sample. Our findings provide an intuitive explanation to the uncovered interest parity puzzle by relating excess currency returns to inflation and business cycle risk.


Discussant: R. Alquist (Bank of Canada)

I found this paper quite interesting as it links up, in an atheoretical/empirical fashion, with the findings Guy Meredith and I obtained — namely that short term interest rate differentials mispredict exchange rate changes, but long term interest rate differentials do not.

On the unstable relationship between exchange rates and fundamentals


*P. Bacchetta (University of Lausanne), E. van Wincoop (University of Virginia)


It is well known from anecdotal, survey and econometric evidence that the relationship between the exchange rate and macro fundamentals is highly unstable. This could be explained when structural parameters are known and very volatile, neither of which seems plausible. Instead we argue that large and frequent variations in the relationship between the exchange rate and macro fundamentals naturally develop when structural parameters in the economy are unknown and change very slowly. We show that the reduced form relationship between exchange rates and fundamentals is driven not by the structural parameters themselves, but rather by expectations of these parameters. These expectations can be highly unstable as a result of perfectly rational “scapegoat” effects. This happens when parameters can potentially change much more in the long run than the short run. This generates substantial uncertainty about the level of parameters, even though monthly or annual changes are small. This mechanism can also be relevant in other contexts of forward looking variables and could explain the widespread evidence of parameter instability found in macroeconomic and financial data. Finally, we show that parameter instability has remarkably little effect on the volatility of exchange rates, the in-sample explanatory power of macro fundamentals and the ability to forecast out of sample.


Discussant: C. Engel (University of Wisconsin)

This paper is closely related to another paper by Bacchetta, Wincoop, and Beutler, discussed in this post from June.

What is driving exchange rates? New evidence from a panel of US dollar bilateral exchange rates


J. Cayen (Bank of Canada), D. Coletti (Bank of Canada), R. Lalonde (Bank of Canada), *P. Maier (Bank of Canada)


Discussant: H. Bouakez (HEC Montreal)


Common risk factors in currency markets


*H. Lustig (UCLA), N. Roussanov (University of Pennsylvania), A. Verdelhan (Boston University)


We identify a ‘slope’ factor in exchange rates. High interest rate currencies load more on this slope factor than low interest rate currencies. As a result, this factor can account for
most of the cross-sectional variation in average excess returns between high and low interest rate currencies. A standard, no-arbitrage model of interest rates with two factors — a country-
specific factor and a global factor — can replicate these findings, provided there is sufficient heterogeneity in exposure to the global risk factor. We show that our slope factor is global risk factor. By investing in high interest rate currencies and borrowing in low interest rate currencies, US investors load up on global risk, particularly during bad times.


Discussant: F. Fornari (European Central Bank)


Crash risk in currency markets


*E. Farhi (Harvard University), X. Gabaix (New York University), A. Verdelhan (Boston University)


Discussant: P. Della Corte (University of Warwick)


Dinner address: J. Murray (Bank of Canada)


Demand imbalances, exchange rate misalignment and monetary policy

Corsetti (European University Institute), L. Dedola (European Central Bank)
S. Leduc (Federal Reserve Bank of San Francisco)


In standard open macro models with incomplete markets, monetary policy geared towards price stability may result in (rather than correcting) misalignments in important asset prices like the exchange rate, even when the latter only reflects fundamental-based valuation. We discuss instances in which optimal monetary policy redresses these inefficiencies, achieving significant welfare gains relative to price stability. These gains are obtained by leaning against an over- or under-valued exchange rate, associated with suboptimal cross-country demand and current account imbalances, consistent with flexible inflation targeting.


Discussant: J. Gali (Centre de Recerca en Economia Internacional)

This paper by Corsetti et al. is an important one, because it’s one of the few papers I know that explicitly defines what real exchange rate misalignment is, in the context of a formal New Keynesian model. I think it, and the discussion by Jordi Gali, are required reading for anybody interested in thinking about equilibrium real exchange rates (a topic discussed here).

The dynamics of international trade invoicing


*L. Goldberg (Federal Reserve Bank of New York), C. Tille (Geneva Graduate Institute)


International trade transactions can be invoiced in the producer currency, in the destination currency, or in some third vehicle currency. This paper shows how an exporter’s invoicing choice is affected by her market share, industry structure, the role of imported inputs, the hedging of macroeconomic shocks, and exchange rate regimes. We address a shortcoming in the existing literature by invoicing choices as the outcome of a bargaining game between exporting producers and their customers abroad. Using a new dataset of 45 million individual Canadian import transactions, we examine the roles of the various invoicing determinants, documenting the importance of each of these factors in the invoicing decisions of specific industry exporters, distinguishing between U.S. exporters and those from other countries.


Discussant: M. Devereux (University of British Columbia)


The predictive information content of external imbalances for exchange rate returns: How much is it worth?


*P. Della Corte (University of Warwick), L. Sarno (Cass Business School), G. Sestieri (European Central Bank)


Discussant: G. M. Milesi-Ferretti (International Monetary Fund)

The authors examine the bilateral version of the Gourinchas-Rey approach, discussed here. The G-R approach is tested against other approaches in Alquist-Chinn.

Keynote speech: On Global Currencies

*J. Frankel (Harvard University)

I approach the state of global currency issues by identifying eight concepts that I see as having recently “peaked” and eight more that I see as currently rising in relevance. Those that I see as having already seen their best days are: the G-7, global savings glut, corners hypothesis, proliferating currency unions, inflation targeting (narrowly defined), exorbitant privilege, Bretton Woods II, and currency manipulation. Those that I see as receiving increased emphasis in the future are: the G-20, the IMF, SDR, credit cycle, reserves, intermediate exchange rate regimes, commodity currencies, and multiple international currency system.

I’ve discussed some of the points Frankel lays out in a previous post, including the idea that “global savings glut” is an idea that is over.

Policy panel discussion: Exchange rate behaviour and policy: Before, during and after the global economic crisis


Chairman: L. Papademos (European Central Bank)


M. Chinn (University of Wisconsin) [presentation]


C. Engel ( University of Wisconsin )


J. Murray (Bank of Canada)

The second meeting (organized by Fabio Ghironi, Boston College, and Nelson Mark, Notre Dame) devoted the Wednesday session to exchange rates:

Order Flows and the Exchange Rate Disconnect Puzzle


Martin Evans, Georgetown University and NBER


The aim of this paper is to establish the link between the high frequency dynamics of spot exchange rates and developments in the macroeconomy. To do so, I first present a theoretical model of exchange-rate determination that bridges the gap between existing microstructure and traditional models. The model examines how dispersed microeconomic information known to individual agents outside the foreign exchange market is aggregated and transmitted to dealers via transaction flows (i.e., order flow); and how the information is then embedded in the spot exchange rate. I then report empirical evidence that strongly supports the presence of the link between the macroeconomy, order flow, and high frequency exchange rate returns implied by the model. In fact, my empirical results indicate that between 20 and 30 percent of the variance in excess currency returns over one- and two-month horizons can be linked back to developments in the macroeconomy. This level of explanatory power is an order of magnitude higher than that found in traditional models — even the newly developed monetary models incorporating central banks reaction functions. Moreover, it provides a straightforward solution to the exchange-rate disconnect puzzle. Namely, the high frequency behavior of spot exchange rates reflects the flow of new information reaching dealers concerning the slowly evolving state of the macroeconomy, rather than the effects of shocks that drive rapidly changing macroeconomic conditions.


Discussant: Menzie Chinn, University of Wisconsin-Madison and NBER [presentation]

A different approach to incorporating order flow (mentioned in my discussion) is contained in Chinn-Moore, discussed here.

Taylor Rules and the Euro


Tanya Molodstva, Emory University, Alex Nikolsko-Rzhevskyy, University of Memphis, David Papell, University of Houston


This paper uses real-time data to show that inflation and either the output gap or unemployment, the variables which normally enter central banks’ Taylor rules for interest-rate-setting, can provide evidence of out-of-sample predictability and forecasting ability for the United States Dollar/Euro exchange rate from the inception of the Euro in 1999 to the end of 2007. We also present less formal evidence that, with real-time data, the Taylor rule provides a better description of ECB than of Fed policy during this period. The strongest evidence is found for specifications that neither incorporate interest rate smoothing nor include the real exchange rate in the forecasting regression, and the results are robust to whether or not the coefficients on inflation and the real economic activity measure are constrained to be the same for the U.S. and the Euro Area. The evidence is stronger with inflation forecasts than with inflation rates and with real-time data than with revised data. Bad news about inflation and good news about real economic activity both lead to out-of sample predictability and forecasting ability through forecasted exchange rate appreciation.


Discussant: Yu-chin Chen, University of Washington [presentation]

This paper is related to my analysis of the in-sample fit of Taylor-rule fundamentals, vs. other macro fundamentals, discussed here.

How Do Different Exporters React to Exchange Rate Changes? Theory, Empirics, and Aggregate Implications


Nicolas Berman, European University Institute, Philippe Martin, Science Po, Paris, Thierry Mayer, Paris School of Economics


This paper analyzes the reaction of exporters to exchange rate changes. We show that, in the presence of distribution costs in the export market, high and low productivity firms react differently to a depreciation . Whereas high productivity firms optimally raise their markup rather than the volume they export, low productivity firms choose the opposite strategy. This heterogeneity has important consequences for the aggregate impact of exchange rate movements. The presence of fixed costs to export means that only high productivity firms can export, firms which precisely react to an exchange rate depreciation by increasing their export price rather than their sales. We show that this selection effect can explain the weak impact of exchange rate movements on aggregate export volumes. We then test the main predictions of the model on a very rich French firm level data set with destination specific export values and volumes on the period 1995-2005. Our results confirm that high performance firms react to a depreciation by increasing their export price rather than their export volume. The reverse is true for low productivity exporters. Pricing to market by exporters is also more pervasive in sectors and destination countries with higher distribution costs. Another result consistent with our theoretical framework is that the probability of firms to enter the export market following a depreciation increases. The extensive margin response to exchange rate changes is modest at the aggregate level because firms that enter, following a depreciation, are less productive and smaller relative to existing firms.


Discussant: Linda Goldberg, Federal Reserve Bank of New York and NBER [presentation]

[Update: Additional links/commentary added 8/11/09, 10:40am Pacific]

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