Monetary Policy and the Predictability of Nominal Exchange Rates

This paper studies how the monetary policy regime affects the relative importance of nominal exchange rates and inflation rates in shaping the response of real exchange rates to shocks. We document two facts about countries with floating exchange rates where monetary policy controls inflation using a short-term interest rate. First, the current real exchange rate predicts future changes in the nominal exchange rate at horizons greater than two years both in sample and out of sample. Second, the real exchange rate is virtually uncorrelated with future inflation rates both in the short run and in the long run. These facts do not hold in countries under quasi-fixed exchange rate regimes, crawling-peg regimes or heavily managed floating exchange rate regimes. We construct an open-economy model that accounts quantitatively for the facts that we document. ∗The views expressed here are those of the authors and do not necessarily reflect the views of the Board of Governors, the Federal Open Market Committee, or anyone else associated with the Federal Reserve System. We thank Adrien Auclert, Charles Engel, Gaetano Gaballo, Zvi Hercovitz, Oleg Itskhoki, Dmitry Mukhin, Paulo Rodrigues, Christopher Sims, and Oreste Tristani for their comments and Martin Bodenstein for helpful discussions.