Exchange Rates and Dominant Macro Fundamental

Abstract

Various exchange rates are driven by different macro variables. This paper uses a measure of exchange rate informativeness about future macro fundamentals to identify the dominant macroeconomic fundamental of 120 currencies. Exchange rate informativeness is defined as the share of future fundamental shocks in the variance of exchange rate changes. The distribution of exchange rate informativeness shows that the median exchange rate informativeness about the dominant macro fundamental is 0.11. Moreover, the exchange rate of most high-inflation countries is driven by expectations of the price differential. Expectations of the relative output drive the currency of countries with high export concentration.