through wealth and substitution effects. Through the information they carry about future profitability and income growth, they also affect activity at both micro- and macroeconomic levels. Moreover, the linkages between asset prices and macroeconomic outcomes play critical roles in the cross-border spillovers of real and financial shocks.

The linkages between exchange rates and macroeconomic outcomes are also multidimensional. Many models look at how exchange rates are endogenously related to macroeconomic variables and how these relationships are affected by a variety of factors, including the heterogeneity of economic sectors, economies of scale, imperfect competition, the type of exchange rate regime, country-specific elements and time horizons. Recent theoretical models employ richer environments, including a consideration of the role of financial variables and valuation effects in developing a better understanding of the linkages between exchange rates and real and financial aggregates. However, some of the links between exchange rates and macroeconomic outcomes remain ambiguous, including with respect to the effects of devaluations on investment and output.

The short-term interest rate is a special asset price since it is the main tool of monetary policy. One of the key channels of monetary transmission, the direct interest rate channel, focuses on the impact of interest rates on economic activity. In standard models, changes in real interest rates lead to movements in the cost of capital and these, in turn, affect business and household investment and consumption decisions.

Empirical evidence. Empirical studies provide evidence supporting some of the basic mechanisms linking asset prices and activity. For example, there is evidence indicating that asset prices affect corporate investment. Research also suggests that linkages arise through a wide range of channels, with their impact depending on the characteristics of financial markets and the types of asset under consideration. Moreover, consistent with the predictions of most models, asset prices tend to be correlated with current and future aggregate activity. And global factors play an increasingly important role in driving variations in asset prices.

The empirical literature documents economically meaningful long-run relationships between exchange rates and economic activity. The strength of these relationships, however, varies across sectors, countries and time horizons. While empirical studies have been inconclusive about the link between exchange rate depreciation and consumption growth, there appears to be stronger long-run links between changes in exchange rates, volume of trade and current account. A number of studies emphasize that exchange rates can play supportive roles in facilitating reversals of current account imbalances. The exchange rate can also affect aggregate activity (as a transmission mechanism of monetary policy), especially in small open economies. In addition, there is a large empirical literature analysing the interaction between exchange rates, financial variables and macroeconomic outcomes.

The role of interest rates in shaping macroeconomic outcomes has also been extensively documented. A number of empirical studies show that interest rates affect investment, consumption and overall activity. The interest rate channel of monetary policy operates with lags and can have asymmetric effects on output. Moreover, certain characteristics of the yield curve can help in explaining the behaviour of various macroeconomic aggregates and can help in predicting the timing of recessions.

Challenges to theoretical and empirical findings. The links between asset prices and activity differ from the predictions of standard models in a number of ways. First, asset prices are much more volatile than fundamentals would imply and can at times deviate, or at least appear to do so, from their predicted fundamental values. The term structure of interest rates is not fully consistent with the simple expectation hypothesis. Although exchange rates can be modelled as the present value of expected fundamentals, they appear to be overly volatile, 43