New Shocks, Exchange Rates And Equity Prices
Source: International Monetary Fund
This paper studies exchange rate and equity price dynamics, in general equilibrium, in the presence of news shocks about future productivity and monetary policy. The author identifies a condition under which these asset prices become more volatile without affecting the volatility of the underlying processes - a positive correlation between news and current shocks. This condition also explains why persistent underlying processes generate volatile asset prices. In addition, the author shows that the correlation between exchange rate and equity returns depends critically on the currency denomination of the equity return and the monetary policy reaction to productivity shocks.