How important are the international financial market imperfections for the foreign exchange rate dynamics: A study of the sterling exchange rate

Abstract

The UK has been a net debtor over the past two decades and the sterling exchange rates are sensitive to any chaos that might occur in the financial market. This paper examines the importance of the international financial imperfections in the sterling exchange rate dynamics. We build a small open economy DSGE model with the constrained international financial institutions that intermediate capital flows, and derive tractable analytical solutions. The constraint works to introduce a wedge between lending and borrowing rates, which compensates financiers for their currency risk-taking. The model has been estimated by using a simulation-based Indirect Inference approach, which provides a natural framework for testing the hypothesis implied by the model. We find that the model cannot be rejected by the UK data. Shocks to financial forces are the main driving forces behind the large and sudden depreciation of the Sterling exchange rates in the aftermath of the collapse of Lehman Brothers and the Brexit vote. Furthermore, the optimal policy rules have been proposed.

UK monetary policy in an estimated DSGE model with financial frictions

“…Now we explore if this M0 policy can work the opposite way -whether a M0 rule in non-ZLB situations can counteract the credit stimulus when the spread falls below normal due to a relaxation of regulatory policy. 16 The M0 rule in normal times takes the same form as for crises:…”

The impact of Economic Policy Uncertainty on the real exchange rate: Evidence from the UK

“…Since the mid-2000s, there has been a significant body of research on the impact of EPU on macroeconomic and financial market outcomes, such as monetary policy, investment decisions, economic growth, exchange rate. In particular, important studies have examined the effect of EPU on firm investment activities (Gulen and Ion, 2016;Nguyen and Phan, 2017), exchange rate volatility (Krol, 2014;Beckmann and Czudaj, 2017;Wang and Morley, 2018), asset prices (Brogaard and Detzel, 2015;Dong et al, 2019), demand for money (Ivanovski and Churchill, 2019), world trade growth (Constantinescu et al, 2019), forecasting future recessions (Karnizova and Li, 2014), exchange rate market pressure (Olanipekun et al, 2019), economic growth (Bloom, 2009), financial trading (Mueller et al, 2017), international commodity markets (Andreasson et al, 2016), and bond market yields (Baker and Bloom, 2013). For a detailed discussion of studies on economic policy uncertainty see Al-Thaqeb, and Algharabali (2019).…”