Collaborative Research: Understanding the Drivers of Exchange Rates through International Asset Prices and Capital Flows

This award funds a research project examining the factors influencing exchange rates, with a focus on international asset prices and capital flows. Understanding the drivers of exchange rates is a central objective of international macroeconomics and finance. Exchange rates are key prices affecting the relative cost of imports and exports, as well as the returns to investing in assets abroad.

Yet exchange rates have long puzzled economists: they are inconsistent with benchmark models in economics and are very difficult to predict. This project makes progress on these puzzles by exploring the relationship between exchange rates and other international asset prices, such as bonds and stocks in different countries, as well as macroeconomic quantities, such as capital flows across borders.

This research helps market participants use exchange rates to better understand macroeconomic conditions in the global economy. It also helps decision-makers better understand how monetary and fiscal policies affect exchange rates and thus the broader economy. The research findings could inspire innovative international policy frameworks, improve the well-being of households, businesses, and investors, and reinforce global market activity.

This award project explores exchange rates through the lens of general equilibrium models with international capital market frictions. These capital market frictions are reflected in a central role for global arbitrageurs to intermediate capital flows across borders. Such models thus allow the researchers to accommodate classic forces that have been thought to drive exchange rates, such as the supply or demand for goods, as well as drivers that have been proposed in more recent research, such as changes in the intermediation capacity of global arbitrageurs.

The project includes research to decompose the drivers of the dollar exchange rate versus other advanced economies through the lens of such a model. The co-movements of exchange rates with bond yields, spreads in financial markets, and capital flows suggest a nuanced variance decomposition of exchange rates: at high frequencies, shocks to intermediation capacity play an important role in driving exchange rates, but at low frequencies and overall, demand shocks play the most important role.

The project includes further research to understand the sources of demand shocks driving variation in these prices and capital flows. The researchers study the co-movements of exchange rates, bonds, and stocks to differentiate between potential sources of demand shocks. The project also includes research to understand how heterogeneous exposures to demand or intermediation shocks can explain differences in exchange rate behavior across countries.

The researchers study how patterns in trade linkages and in net foreign assets give rise to heterogeneous effects of these shocks. The project finally includes research on the propagation of macroeconomic policies through exchange rates. The researchers study whether state-dependence in the effects of foreign exchange rate intervention can account for mixed evidence on its effectiveness in the data.

This research could help researchers and decision-makers gain deeper insights into exchange rates and their relationship with international asset prices, capital flows, and other macroeconomic factors, ultimately improving the well-being of the U.S. population and strengthening the country's leadership in international markets.

This award reflects NSF's statutory mission and has been deemed worthy of support through evaluation using the Foundation's intellectual merit and broader impacts review criteria.