Authors:

Paul Kim

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About Paper:

jhornsten@northwestern.edu Currencies can depreciate against the US dollar without any traditional rationale to explain the episodes. Sometimes, government Officials attribute this to capital outflows, but this logic is rather circular: exchange rates could depreciate when resident capital flows out. The relevant question then becomes why residents choose to move capital overseas. This thesis examines whether global risk factors or concerns over the fiscal debasement channel better explain currency depreciation in modern floating-rate regimes, while recognizing that country-specific structural characteristics, such as political instability, may affect both channels. The global risk framework treats currencies as risk assets, whose returns are affected by US monetary policy and global risk sentiments. The fiscal debasement channel, empirically connected to the Fiscal Theory of the Price Level, argues that depreciation reflects forward looking evaluations of debt sustainability, which are transmitted through resident portfolio rebalancing. We test these two mechanisms using a panel of sixteen floating-rate currencies over the years 2001 to 2024. The empirical strategy includes cross-sectional analysis, panel regression with penalized variable selection using LASSO, threshold detection, and regime-switching estimation. The inflation differential between the US and the respective country emerges as the strongest predictor across different specifications. The lagged government debt indicator is positively associated with depreciation, and there is evidence of a nonlinear threshold near 78 percent of GDP in which the fiscal channel intensifies. The transmission of effects from fundamentals to exchange rates shifts across volatility regimes, as interest rate differentials and monetary policy conditions matter the most during periods of relative calamity, while global risk and fiscal structures become more important during periods of financial stress. These regime-dependent dynamics help explain why the relationship between macroeconomic fundamentals and exchange rate movements has appeared relatively unstable across our sample period coverage.

Source:

Northwestern University

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Co-authors:

Paul Kim