Risk, monetary policy, and the exchange rate

In this research, we provide new empirical evidence on the importance of time- varying uncertainty for the exchange rate and the excess return in currency markets. Following an increase in monetary policy uncertainty, the dollar exchange rate appreciates in the medium run, while an increase in the volatility of productivity leads to a dollar depreciation. We propose a general- equilibrium theory of exchange rate determination based on the interaction between monetary policy and time varying uncertainty aimed at understanding these regularities. In the model, the behavior of the exchange rate following nominal and real volatility shocks is consistent with the empirical evidence. Furthermore, we show that risk factors and interest- rate smoothing are important in accounting for the negative coefficient in the UIP regression. © 2012 by the National Bureau of Economic Research.