Working Paper: NBER ID: w17133
Authors: Gianluca Benigno; Pierpaolo Benigno; Salvatore Nisticò
Abstract: In this research, we provide new empirical evidence on the importance of time-varying uncertainty for the exchange rate and the excess return in currency markets. Following an increase in monetary policy uncertainty, the dollar exchange rate appreciates in the medium run, while an increase in the volatility of productivity leads to a dollar depreciation. We propose a general-equilibrium theory of exchange rate determination based on the interaction between monetary policy and time-varying uncertainty aimed at understanding these regularities. In the model, the behaviour of the exchange rate following nominal and real volatility shocks is consistent with the empirical evidence. Furthermore we show that risk factors and interest-rate smoothing are important in accounting for the negative coefficient in the UIP regression.
Keywords: Monetary Policy; Exchange Rate; Volatility; Uncovered Interest Parity
JEL Codes: E0; E43; E52; F3; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increase in monetary policy uncertainty (E49) | appreciation of the dollar exchange rate (F31) |
| increase in productivity volatility (O49) | depreciation of the dollar exchange rate (F31) |
| nominal volatility shocks (E39) | appreciation of the dollar exchange rate (F31) |
| real volatility shocks (E39) | depreciation of the dollar exchange rate (F31) |
| risk factors and interest rate smoothing (E43) | negative coefficient in UIP regression (C29) |
| volatility shocks (E32) | impact on equilibrium levels of exchange rates and interest rates (F31) |
| increase in nominal volatility (E39) | tendency to appreciate the exchange rate (F31) |
| increase in real volatility (E39) | tendency to depreciate the exchange rate (F31) |