On the Driving Forces of Real Exchange Rates: Is the Japanese Yen Different?
70 Pages Posted: 16 Sep 2014 Last revised: 10 Nov 2019
Date Written: November 8, 2019
We estimate variance decompositions of the real exchange rates for 19 individual currencies based on a present-value relation. We document substantial heterogeneity across forecasting horizons and currencies regarding the determinants of exchange rates. At short horizons, the dominant force is predictability of the future spot rates. At long horizons, return predictability drives most of the variation in exchange rates, with predictability of interest differentials playing a secondary role. However, for the Japanese Yen (JPY) the main determinant is long-run interest spread predictability, a pattern that occurs in the most recent period. We develop a liquidity-based exchange rate model to explain such evidence. Agents value the liquidity benefit of near-money assets and have non-separable utility over consumption and liquidity services. Cross-country differentials in liquidity demand determine exchange rates and affect both interest differentials and risk premiums in a way consistent with the data. The quantitative simulation correctly replicates our empirical findings.
Keywords: exchange rates, currency return and interest spread predictability, Japanese Yen, variance decompositions, present-value relation, liquidity premium, calibration and simulation
JEL Classification: F31, G12, G15, G17
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