Exchange rates are influenced by macroeconomic performance: Buba paper

Macroeconomic fundamentals can influence exchange rates through changes in the expectation of monetary policies, a Bundesbank paper published, on Friday, says.

Qianying Chen, the paper's author, uses data on the Deutsche mark, the Canadian dollar, Japanese yen and the British pound relative to the US dollar from 1979 to 2008 to investigate the implications of monetary policy rules on changes in exchange rate. While past literature has favoured the view that exchange rate dynamics are unrelated to macroeconomic fundamentals, recent studies have pointed to a link between fundamentals and exchange rates.

The results show that through the expectations of future monetary policy, Taylor rule fundamentals are able to forecast changes in the exchange rate, even over short-term horizons of less than two years. Chen finds that the market expectation formation processes of short-term interest rates changes over time and differs across countries, which contributes to the time-varying relationship between exchange rates and macroeconomic fundamentals.

Click here to read the paper.