A Fundamental Connection: Exchange Rates and Macroeconomic Expectations
An emerging perception in international economics is that exchange rates are disconnected contemporaneously from macroeconomic fundamentals and are instead more closely tied to financial variables, particularly asset prices. The authors argue that this notion is incorrect. They use novel econometric methods to show that, while quarterly exchange rate changes are tightly linked to movements in currency risk premia, new information revealed by announcements about macroeconomic indicators can explain much of the variation in these risk premia. They also show that this same macroeconomic news also explains most of the variation in exchange rate changes at a quarterly frequency and that this news has even greater explanatory power during economic downturns and periods of financial uncertainty.