On the Driving Forces of Real Exchange Rates : Is the Japanese Yen Different?

We estimate variance decompositions of the real exchange rates for 19 currencies based on a present-value relation. We document substantial heterogeneity across forecasting horizons and currencies. At short horizons, the dominant force is predictability of the future spot rates. At long horizons, return predictability drives most variation in exchange rates, with predictability of interest differentials playing a secondary role. However, for the Japanese Yen the main determinant is long-run interest spread predictability, a pattern that occurs in the most recent period. We develop a liquidity-based exchange rate model to explain such evidence. The quantitative simulation largely replicates our empirical findings