Real Exchange Rate Decompositions
Why does the exchange rate change? In this paper, we break down the exchange rate between the Canadian and US dollars into its fundamental components: the expected difference of inflation rates and differences between the yield curves of each country, as well as a foreign exchange risk premium.
Separating currency movements into these components sheds light on the well-documented disconnect between macroeconomic fundamentals and exchange rates. In fact, we explicitly model the link between fixed income and currency markets to learn more about how they are connected.
Using data since 2008, we provide evidence that exchange rate movements are driven largely by a risk premium channel. In contrast, the impact of the expected differences of inflation rates and the differences of yield curves on the exchange rate are comparably muted for most of the 2008–2021 period. When we narrow our focus to monetary policy announcements and macroeconomic data releases, we also find that the response of the Canadian dollar exchange rate can be largely attributed to adjustments in the foreign exchange risk premium.