Description:
This paper proposes a theoretical model that combines a present value model of the exchange rate with a variance-belief formation model to investigate the relationship between macroeconomic uncertainty and the exchange rate. The model emphasizes the risk premium as its core and incorporates macroeconomic uncertainty as a factor of the conditional variance of the exchange rate. Empirical evidence is analyzed using the Perceived Macroeconomic Uncertainty (PMU) index and multi-country data, indicating that an economy’s increase in PMU relative to the U.S. results in a depreciation of thecurrent and next period’s spot rate, with persistent effects from PMU shocks. The study suggests a negative risk-return relationship in the short run, consistent with behavioral finance models and empirical literature. Overall, this study provides more insight into the role of fundamentals in exchange rate movements and the risk-return relationship in the FX market with a focus on macroeconomic uncertainty