Exchange Rates, Natural Rates, and the Price of Risk

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Abstract

We study the source of exchange rate fluctuations using a general equilibrium model accommodating shocks in goods and financial markets.  These shocks differ in their induced comovements between exchange rates, interest rates, and quantities.  A calibration matching data from the U.S. and G10 currency countries implies that persistent shocks to relative demand, reflected in persistent interest rate differentials, account for 75% of the variance in the dollar/G10 exchange rate.   Shocks to currency intermediation are important, however, in generating deviations from uncovered interest parity at high frequencies and explaining the dollar appreciation in crises.