April 2017 (Revised November 2017)

Monetary Policy and the Predictability of Nominal Exchange Rates

Martin Eichenbaum, Benjamin K. Johannsen, and Sergio Rebelo


This paper documents 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. This predictability improves with the length of the horizon. Second, the real exchange rate is virtually uncorrelated with future inflation rates both in the short run and in the long run. We show that a large class of open-economy models is consistent with these findings and that, empirically and theoretically, the ability of the real exchange rate to forecast changes in the nominal exchange rate depends critically on the nature of the monetary regime.

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Original paper: PDF | Accessible materials (.zip)

Keywords: Exchange rates and foreign exchange, Monetary policy

DOI: https://doi.org/10.17016/FEDS.2017.037r1

PDF: Full Paper

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Last Update: January 09, 2020