Central Bank Credibility and Exchange Rate Determination with Financial Intermediaries

Financial intermediaries play a key role in determining exchange rates by adjusting international risk-sharing in response to volatility. This thesis seeks to answer how imperfect central bank credibility impacts this equilibrium risk-sharing and, by extension, the real economy. I build a two country model with financial intermediaries by introducing a credibility driven jump-diffusion process for the carry trade return. I solve for the optimal portfolio choice of intermediaries, showing that it features a novel credibility-driven hedging term. Using this result, the model predicts that equilibrium deviations from uncovered interest parity and changes to the Backus–Smith residual are partially driven by shocks to credibility. I test this hypothesis in the US–South Korea setting and find that credibility shocks contribute significantly to both of these measures, appearing empirically on both the financial and real side of the economy. Finally, I investigate dynamic effects of credibility shocks in general equilibrium, showing that negative shocks have persistent deleterious macroeconomic effects by reducing consumer spending, driving increases in inflation and exchange rate depreciation, and raising borrowing costs.