Working Paper: NBER ID: w26259
Authors: Philippe Bacchetta; Eric van Wincoop
Abstract: The objective of this paper is to show that the proposal by Froot and Thaler (1990) of delayed portfolio adjustment can account for a broad set of puzzles about the relationship between interest rates and exchange rates. The puzzles include: i) the delayed overshooting puzzle; ii) the forward discount puzzle (or Fama puzzle); iii) the predictability reversal puzzle; iv) the Engel puzzle (high interest rate currencies are stronger than implied by UIP); v) the forward guidance exchange rate puzzle; vi) the absence of a forward discount puzzle with long-term bonds. These results are derived analytically in a simple two-country model with portfolio adjustment costs. Quantitatively, this approach can match all targeted moments related to these puzzles.
Keywords: No keywords provided
JEL Codes: F3; F31; F41; G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Monetary contraction raises interest rate (E43) | Initial appreciation of currency (F31) |
| Initial appreciation of currency (F31) | Gradual depreciation of currency (F31) |
| High interest rate currencies expected to appreciate more than UIP (F31) | Direct effect of interest rates on exchange rates (E43) |
| Prior interest rate differentials (E43) | Initially high interest rate currencies exhibit positive expected excess returns (F31) |
| Initially high interest rate currencies exhibit positive expected excess returns (F31) | Turn negative over time (D15) |
| High interest rate currencies stronger than UIP (F31) | Direct causal relationship of interest rates on exchange rate strength (E43) |
| Current exchange rate responsive to near-term interest differentials (F31) | Direct influence of current expectations on immediate exchange rate movements (F31) |
| Model explains why long-term bonds do not exhibit same forward discount behavior as short-term bonds (E43) | Divergence in expected returns based on bond duration (G19) |