Sources of Exchange Rate Fluctuations: Are They Real or Nominal?

Abstract:     
I analyze the role of real and monetary shocks on the exchange rate behavior using a structural vector autoregressive model of the US vis-à-vis the rest of the world. The shocks are identified using sign restrictions on the responses of the variables to orthogonal disturbances. These restrictions are derived from the predictions of a two-country DSGE model. I find that monetary shocks are unimportant in explaining exchange rate fluctuations. By contrast, demand shocks explain between 21% and 37% of exchange rate variance at 4-quarter and 20-quarter horizons, respectively. The contribution of demand shocks plays an important role but not of the order of magnitude sometimes found in earlier studies. My results, however, support the recent focus of the literature on real shocks to match the empirical properties of real exchange rates.

Number of Pages in PDF File: 38

Keywords: Exchange Rates, Real Shocks, Monetary Shocks, Vector Autoregression, Sign Restrictions

JEL Classification: F31, F41, C30

working papers series