The Dollar Exchange Rate and Interest Parity : Letting Different Views Compete

The extant structural vector autoregression (SVAR) literature typically focuses on one shock at a time when studying the behavior of the exchange rates, which risks confounding the identified shock with the endogenous responses to the unidentified shocks. This paper proposes a novel SVAR approach to jointly evaluate the contributions of anticipated technology shocks, monetary shocks, safe asset demand shocks, and persistent interest rate shocks to exchange rate movements. Our empirical analysis establishes the following main findings: First, we document that the exchange rate responds to the four structural shocks in distinct patterns. Second, anticipated technology shocks and persistent interest rate shocks are more important contributors to the exchange rate dynamics than monetary shocks and safe asset demand shocks. Third, we develop a novel conditional uncovered interest parity (UIP) test based on counterfactual data, which demonstrates that the UIP tends to fail conditional on monetary shocks and persistent interest rate shocks. There is no sufficient evidence to reject the UIP following anticipated technology shocks or safe asset demand shocks