Exchange Rates and the Term Structure of Interest Rates

It is shown that the empirical performance of asset-market models of exchange rates for key currencies can be improved by including information about the term structure of interest rate differentials. The paper extends a portfolio-balance model by including both long- and short-term interest rates as determining variables. Estimation of the model indicates that real exchange rates for the United States, Japan, and the Federal Republic of Germany are affected both by nominal short-term interest differentials and by real long-term differentials.