DP18119 A Fundamental Connection: Exchange Rates and Macroeconomic Expectations
One of the most famous puzzles in international finance is the disconnect between exchange rates and macroeconomic fundamentals at business cycle frequencies. We disprove this puzzle by showing that the majority of variation in exchange rates at
monthly and quarterly frequencies can be explained by macroeconomic news, which account for as much as 91 percent of the quarterly exchange rate variation during periods of US economic recessions and 64 percent over all periods. The main driver
of the reconnect is exchange rates responding to past rather than contemporaneous news—a result inconsistent with the theory of uncovered interest rate parity (UIP). We discuss a number of theoretical models that can explain this surprising result.
These include models featuring deviation from UIP due to the presence of currency risk premia, regulatory or institutional frictions, or models featuring deviation from full information rational expectations.