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Exchange rates and fundamentals: a non-linear relationship?

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Author Info
Paul De Grauwe (Katholieke Universiteit Leuven, Belgium)
Isabel Vansteenkiste

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Abstract

We test whether the relationship between changes in the nominal exchange rate and changes in its underlying fundamentals has non-linear features. In order to do so, we extend the Markov-switching model as proposed by McConnell and Perez Quiros (2000) and Dewachter (2001) and test it using a sample of low- and high-inflation countries. The empirical analysis shows that for the high-inflation countries the relationship between news in the fundamentals and the exchange rate changes is stable and significant. This is not the case, however, for the low-inflation countries, where frequent regime switches occur. We develop a non-linear model based on the existence of transactions costs that could explain our empirical findings. We find that this simple non-linear model is capable of replicating the empirical evidence uncovered in this paper. Copyright © 2007 John Wiley & Sons, Ltd.

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File URL: http://hdl.handle.net/10.1002/ijfe.310
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Article provided by John Wiley & Sons, Ltd. in its journal International Journal of Finance & Economics.

Volume (Year): 12 (2007)
Issue (Month): 1 ()
Pages: 37-54
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Handle: RePEc:ijf:ijfiec:v:12:y:2007:i:1:p:37-54

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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  3. Robert P. Flood & Andrew K. Rose, 1993. "Fixing Exchange Rates: A Virtual Quest for Fundamentals," NBER Working Papers 4503, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  4. Carlo Altavilla, 2000. "Measuring Monetary Policy Assymmetries across EMU Countries," Center for Economic Studies - Discussion papers ces0022, Katholieke Universiteit Leuven, Centrum voor Economische Studiën. [Downloadable!]
  5. Charles Engel & Craig S. Hakkio, 1994. "The distribution of exchange rates in the EMS," Research Working Paper 94-03, Federal Reserve Bank of Kansas City.
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  6. Maurice Obstfeld & Kenneth Rogoff, 2000. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," NBER Working Papers 7777, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  7. Faust, Jon & Rogers, John H. & H. Wright, Jonathan, 2003. "Exchange rate forecasting: the errors we've really made," Journal of International Economics, Elsevier, vol. 60(1), pages 35-59, May. [Downloadable!] (restricted)
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  8. Fratzscher, M., 1999. "What Causes Currency Crises: Sunspots, Contagion or Fundamentals?," Economics Working Papers eco99/39, European University Institute.
  9. De Grauwe, Paul, 1994. "Exchange Rates in Search of Fundamental Variables," CEPR Discussion Papers 1073, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  11. Paul Grauwe & Hans Dewachter, 1993. "A chaotic model of the exchange rate: The role of fundamentalists and chartists," Open Economies Review, Springer, vol. 4(4), pages 351-379, December. [Downloadable!] (restricted)
  12. Sercu, Piet & Uppal, Raman & Van Hulle, Cynthia, 1995. " The Exchange Rate in the Presence of Transaction Costs: Implications for Tests of Purchasing Power Parity," Journal of Finance, American Finance Association, vol. 50(4), pages 1309-19, September. [Downloadable!] (restricted)
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  19. Taylor, Mark P. & Peel, David A., 2000. "Nonlinear adjustment, long-run equilibrium and exchange rate fundamentals," Journal of International Money and Finance, Elsevier, vol. 19(1), pages 33-53, February. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Paul De Grauwe & Marianna Grimaldi, 2003. "Intervention in the Foreign Exchange Market in a Model with Noise Traders," Working Papers 162003, Hong Kong Institute for Monetary Research. [Downloadable!]
  2. Yin-Wong Cheung & Ulf G. Erlandsson, 2004. "Exchange Rates and Markov Switching Dynamics," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
    Other versions:
  3. Carlo Altavilla & Paul De Grauwe, 2005. "Non-Linearities in the Relation between the Exchange Rate and its Fundamentals," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
  4. Serineh Najarian & H. L. Leon, 2003. "Asymmetric Adjustment and Nonlinear Dynamics in Real Exchange Rates," IMF Working Papers 03/159, International Monetary Fund. [Downloadable!]
  5. Hyginus Leon & Serineh Najarian, 2005. "Asymmetric adjustment and nonlinear dynamics in real exchange rates," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 10(1), pages 15-39. [Downloadable!]
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