A linear econometric error correction model (ECM) model is built, based on short interest rates, gross domestic product (GDP) growth expectations and inflation differ entials, in order to explain the euro/dollar exchange rate dynamics and provide reliable forecasts. This specification performs well. However, the introduction of non-linear threshold dynamics provides a better understanding of 'abnormal' features other than deviations from long-run equilibrium levels, allowing for the possibility of asymmetric behaviour. Empirical evidence of this is found in the actual dynamics of the euro. The non-linear specification performs better than the linear model in both in-sample fitting and out-of-sample forecasting, showing that fundamentals hold, working also through some non-linear mechanism, in explaining the euro/dollar dynamics.
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Volume (Year): 8 (2002) Issue (Month): 4 (December) Pages: 422-448 Download reference. The following formats are available: HTML
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