Exchange rates tell us how much one currency is worth in terms of another. They fluctuate constantly, due to changes in interest rates, economic conditions, and financial markets. Predicting exchange rates has long puzzled economists, however, because they often don’t behave the way standard economic models suggest. For example, currencies often deviate from uncovered interest parity: A theory stating that exchange rates should adjust so that the difference in interest rates between two countries is offset by expected changes in their currencies, leaving no opportunity for expected profit from interest rate differences. (UIP)—the idea that higher interest rates in one country should lead to currency depreciation to offset returns.
In this paper, the authors explore why the dollar/G10 exchange rate: An index representing the average exchange rate between the U.S. dollar and the G10 currencies (those of Australia, Canada, Denmark, the Euro area, Japan, New Zealand, Norway, Sweden, Switzerland, and the United Kingdom). changes over time. They construct a model that simulates the impacts of three types of shocks: demand shocks (which reflect changes in how much households and businesses wish to spend or invest), currency intermediation shocks: A disruption in financial markets that impacts exchange rates, such as a change in financial institutions’ willingness to intermediate currency trades or a global flight to the safety of the U.S. dollar. (disruptions in financial markets that affect the returns to currency trades), and supply shocks (which affect the production and availability of goods). The authors ensure that their model’s output matches historical data on bond yields, exchange rates, and consumption from 1991 to 2020. Using their model to better understand how different shocks interact and drive exchange rate movements, the authors find the following:
- Persistent demand shocks—characterized by lasting shifts in economic conditions like credit availability, demographic trends, or growth expectations—play a crucial role in driving changes in the dollar/G10 exchange rate, accounting for about 75% of the fluctuations between the dollar and a group of 10 advanced economies’ currencies, including the Euro, Japanese yen, and British pound.
- While demand shocks play the largest role in driving the dollar/G10 exchange rate, currency intermediation shocks are also important to understanding exchange rates at high frequencies. These shocks generate short-term deviations from UIP and are particularly impactful during financial crises, when the dollar strengthens despite low U.S. bond yields.
- Supply shocks have a limited effect on exchange rates.
This research suggests that persistent shocks to relative demand, reflected in persistent differences in interest rates, are the main reason behind exchange rate movements. Policymakers should recognize that these fluctuations are not entirely under the control of monetary policy but reflect broader economic forces like consumption and investment trends. Financial market stability is also crucial, as disruptions can amplify currency volatility, particularly during crises. Going forward, future research could explore what causes these shifts in relative demand across countries and how exchange rate behavior differs between advanced and emerging markets.