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Exchange rate as a monetary-fiscal phenomenon

I develop a framework that connects exchange rates to monetary and fiscal policies. In my framework, government is like a company. On the one hand, each government has liabilities, which are mostly debt denominated in local currency. On the other hand, each government also has earnings, which are tax revenues net of government spendings. The government's liabilities are affected by its monetary policy, while its earnings are affected by its fiscal policy. Because the government uses its earnings to pay back its local currency debt, the value of the local currency reflects the present value of government surpluses per unit of government debt. This relationship predicts that exchange rates comove with fiscal conditions, and that currency risk premia are determined by the cyclicalities of government earnings, both of which are validated in the data.

US Fiscal Cycle and the Dollar

I develop a VAR framework to estimate the term structure of the dollar's risk premium and attribute its variation to various sources. The term structure varies significantly over time, accounts for the dollar's exchange rate movement, and comoves with US equity and bond risk premia. While the dollar's short-term risk premium loads on the US fiscal cycle, interest rate differential, liquidity premium and the real exchange rate, its long-term risk premium only loads on the US fiscal cycle. When I compare the term structure dynamics with leading asset pricing models, a new volatility puzzle emerges.

Foreign Safe Asset Demand and the Dollar Exchange Rate