On the Driving Forces of Real Exchange Rates: Is the Japanese Yen Different?
70 Pages Posted: 16 Sep 2014 Last revised: 12 Sep 2023
Date Written: September 1, 2023
Abstract
We estimate variance decompositions of the real exchange rate (q) for 19 currencies based
on a present-value relation. At very short horizons, the driving force of q is predictability of
the future exchange rate. At long horizons, return predictability drives most variation in q,
with predictability of interest differentials playing a secondary role. This pattern is especially
strong for the Non-G10 currencies. However, the long-run predictability mix associated with
the Japanese Yen clearly deviates from the other currencies and is unstable over time. The
quantitative simulation of a liquidity-based exchange rate model largely replicates our main
empirical findings.
Keywords: currency return and interest spread predictability, Japanese Yen, variance decompositions, present-value relation, liquidity premium, calibration and simulation
JEL Classification: F31, G12, G15
Suggested Citation: Suggested Citation