Monetary Policy and the Predictability of Nominal Exchange Rates

68 Pages Posted: 10 Apr 2017 Last revised: 15 Nov 2017

See all articles by Martin Eichenbaum

Martin Eichenbaum

Northwestern University; National Bureau of Economic Research (NBER)

Benjamin Kramer Johannsen

Board of Governors of the Federal Reserve System

Sergio T. Rebelo

Northwestern University - Kellogg School of Management; Centre for Economic Policy Research (CEPR); University of Rochester - Department of Economics; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: 2017-02

Abstract

This paper documents two facts about countries with floating exchange rates where monetary policy controls inflation using a short-term interest rate. First, the current real exchange rate predicts future changes in the nominal exchange rate at horizons greater than two years both in sample and out of sample. This predictability improves with the length of the horizon. Second, the real exchange rate is virtually uncorrelated with future inflation rates both in the short run and in the long run. We show that a large class of open-economy models is consistent with these findings and that, empirically and theoretically, the ability of the real exchange rate to forecast changes in the nominal exchange rate depends critically on the nature of the monetary regime.

Keywords: Exchange rates and foreign exchange, Monetary policy

JEL Classification: E52, F31

Suggested Citation

Eichenbaum, Martin and Johannsen, Benjamin Kramer and Tavares Rebelo, Sergio, Monetary Policy and the Predictability of Nominal Exchange Rates (2017-02). FEDS Working Paper No. 2017-037. Available at SSRN: https://ssrn.com/abstract=2949243 or http://dx.doi.org/10.17016/FEDS.2017.037r1

Martin Eichenbaum (Contact Author)

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Benjamin Kramer Johannsen

Board of Governors of the Federal Reserve System ( email )

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Sergio Tavares Rebelo

Northwestern University - Kellogg School of Management ( email )

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