A Fundamental Connection: Exchange Rates and Macroeconomic Expectations

Stavrakeva, V and Tang, J (2024) A Fundamental Connection: Exchange Rates and Macroeconomic Expectations. Review of Economics and Statistics. ISSN 0034-6535 (In Press)

Abstract

We disprove the exchange rate macroeconomic disconnect puzzle by showing that macroeconomic news can explain most variation in exchange rates at monthly and quarterly frequencies, accounting for up to 91 percent of the quarterly exchange rate variation during US recessions and 65 percent over all periods. The main driver of the reconnect is exchange rates responding to past news—a result inconsistent with the theory of uncovered interest rate parity under full information rational expectations (UIP-FIRE). We discuss theoretical models that can explain this surprising result, including models featuring currency risk premia, regulatory or institutional frictions, or deviation from FIRE.