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Non-Linearities in the Relation between the Exchange Rate and its Fundamentals

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Author Info
Carlo Altavilla ()
Paul De Grauwe ()

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Abstract

This paper investigates the relationship between the euro-dollar exchange rate and its underlying fundamentals. First, we develop a simple theoretical model in which chartists and fundamentalists interact. This model predicts the existence of different regimes, and thus non-linearities in the link between the exchange rate and its fundamentals. Second, we account for non-linearity in the exchange rate process by adopting a Markov-switching vector error correction model (MSVECM). Finally, the paper investigates the out-of-sample forecast performance of three competing models of exchange rate determination. The results suggest the presence of nonlinear mean reversion in the nominal exchange rate process. The implications are that different sets of macroeconomic fundamentals act as driving forces of the exchange rates during different time periods. More interestingly, the nonlinear specification significantly improves the forecast accuracy during periods when the deviation between exchange rate and fundamentals is large. Conversely, when the exchange rate is close to its equilibrium value it tends to be better approximated by a naïve random walk.

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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number CESifo Working Paper No. 1561.

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Date of creation: 2005
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Handle: RePEc:ces:ceswps:_1561

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Related research
Keywords: non-linearity; Markov-switching model; fundamentals;

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Find related papers by JEL classification:
C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions
F31 - International Economics - - International Finance - - - Foreign Exchange

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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. Fabrice Capoen & Jerome Creel, 2007. "Efficiency of stability-oriented institutions: the European case," Documents de Travail de l'OFCE 2007-06, Observatoire Francais des Conjonctures Economiques (OFCE). [Downloadable!]
  2. Carlo Altavilla & Paul De Grauwe, 2006. "Forecasting and Combining Competing Models of Exchange Rate Determination," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
    Other versions:
  3. Michael Kühl, 2008. "Strong comovements of exchange rates: Theoretical and empirical cases when currencies become the same asset," cege – Center for European, Governance and Economic Development Research Discussion Papers 76, cege – Center for European, Governance and Economic Development Research, University of Goettingen (Germany)., revised 03 Sep 2008. [Downloadable!]
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