DP11844 Monetary Policy and the Predictability of Nominal Exchange Rates

Author(s): Martin Eichenbaum, Benjamin Johannsen, Sérgio Rebelo
Publication Date: February 2017
Keyword(s): currency forecasting, Taylor rule
JEL(s): E52, F31, F41
Programme Areas: International Macroeconomics and Finance
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=11844

This paper documents two facts about the behavior of floating exchange rates in countries where monetary policy follows a Taylor-type rule. First, the current real exchange rate is highly negatively correlated with future changes in the nominal exchange rate at horizons greater than two years. This negative correlation is stronger the longer is the horizon. Second, for most countries, the real exchange rate is virtually uncorrelated with future inflation rates both in the short and in the long run. We develop a class of models that can account for these and other key observations about real and nominal exchange rates.