On the driving forces of real exchange rates: Is the Japanese Yen different?

Abstract

We estimate variance decompositions of the real exchange rate ($q$) for 19 currencies based on a present-value relation. At very short horizons, the driving force of $q$ is predictability of the future exchange rate. At long horizons, return predictability drives most variation in $q$, with predictability of interest differentials playing a secondary role. This pattern is especially strong for the Non-G10 currencies. However, the long-run predictability mix associated with the Japanese Yen clearly deviates from the other currencies and is unstable over time. The quantitative simulation of a liquidity-based exchange rate model largely replicates our main empirical findings.