Exchange rates and expectations In this chapter, we emphasised that expectations have an important effect on the exchange rate. In this problem, we use data to get a sense of how large a role expectations play. Using the results in Appendix 2 at the end of the chapter, you can show that the uncovered interest parity condition, equation

(19.4), can be written as

≈ (it − i*t ) − (it−1 − i*t−1) +

In words, the percentage change in the exchange rate (the appreciation of the domestic currency) is approximately equal to the change in the interest rate differential (between domestic and foreign interest rates) plus the percentage change in exchange rate expectations (the appreciation of the expected domestic currency value). We shall call the interest rate differential the spread.

a. Go to the website of the Bank of England

(www.bankofengland.co.uk) and obtain data on the three-month Treasury bill rate for the past ten years.
Download the data into a spreadsheet. Now go to the website of the European Central Bank (www.ecb.int)
and download data on the three-month interbank rate (EURIBOR after 1999) for the same time period. For each month, subtract the UK interest rate from the euro interest rate to calculate the spread. Then, for each month, calculate the change in the spread from the preceding month. (Make sure to convert the interest rate data into the proper decimal form.)

b. At the website of the European Central Bank, obtain data on the monthly exchange rate between the euro and the UK pound for the same period as your data from part (a).
Again, download the data into a spreadsheet. Calculate the percentage appreciation of the euro for each month.
Using the standard deviation function in your software, calculate the standard deviation of the monthly appreciation of the euro. The standard deviation is a measure of the variability of a data series.

c. For each month, subtract the change in the spread (part (a)) from the percentage appreciation of the dollar (part (b)). Call this difference the change in expectations.
Calculate the standard deviation of the change in expectations. How does it compare to the standard deviation of the monthly appreciation of the dollar?
There are some complications we do not take into account here. Our interest parity condition does not include a variable that measures relative asset demand. We explored the implications of changes in relative asset demands in problem 12 at the end of Chapter 18.

In addition, changes in interest rates and expectations may be related. Still, the gist of this analysis survives in more sophisticated work. In the short run, observable economic fundamentals do not account for much of the change in the exchange rate. Much of the difference must be attributed to changing expectations.