Working Paper

Monetary Policy and the Predictability of Nominal Exchange Rates

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;

https://doi.org/10.17016/FEDS.2017.037r1

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2017-11-13

Number: 2017-037

Pages: 67 pages