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. Out-of-sample forecasts based on the real exchange rate outperform random walk models at medium and long horizons. Second, the real exchange rate is a poor predictor of future inflation rates. 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