Rare disasters, exchange rates, and macroeconomic policy: Evidence from COVID-19

The rapid spread of the novel coronavirus (COVID-19) has had a dramatic effect on financial markets worldwide. This paper explores the association between rare disasters, macroeconomic policy, and the exchange rate, using COVID-19 as an example. Analysis of data from 27 advanced and emerging economies reveals a strong correlation between COVID-19 and time-varying risk premiums in the foreign exchange market. Moreover, the spread of COVID-19 significantly depreciates the domestic exchange rate in emerging markets, but not in advanced countries. During the COVID-19 crisis, expansionary fiscal policies and unconventional monetary policies led to an appreciation of local currencies. However, conventional expansionary monetary policies had the opposite effect, indicating that the traditional effect of monetary policy on the exchange rate takes precedence even in the event of a rare disaster. (c) 2021 Elsevier B.V. All rights reserved.