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On the Unstable Relationship between Exchange Rates and Macroeconomic Fundamentals

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  • Philippe Bacchetta

    (University of Lausanne, Centre for Economic Policy Research, Hong Kong Institute for Monetary Research)

  • Eric van Wincoop

    (University of Virginia, National Bureau of Economic Research, Hong Kong Institute for Monetary Research)

Abstract

It is well known from anecdotal, survey and econometric evidence that the relationship between the exchange rate and macro fundamentals is highly unstable. This could be explained when structural parameters are known and very volatile, neither of which seems plausible. Instead we argue that large and frequent variations in the relationship between the exchange rate and macro fundamentals naturally develop when structural parameters in the economy are unknown and change very slowly. We show that the reduced form relationship between exchange rates and fundamentals is driven not by the structural parameters themselves, but rather by expectations of these parameters. These expectations can be highly unstable as a result of perfectly rational "scapegoat" effects. This happens when parameters can potentially change much more in the long run than the short run. This generates substantial uncertainty about the level of parameters, even though monthly or annual changes are small. This mechanism can also be relevant in other contexts of forward looking variables and could explain the widespread evidence of parameter instability found in macroeconomic and financial data. Finally, we show that parameter instability has remarkably little effect on the volatility of exchange rates, the in-sample explanatory power of macro fundamentals and the ability to forecast out of sample.

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Bibliographic Info

Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 272009.

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Length: 51 pages
Date of creation: Aug 2009
Date of revision:
Handle: RePEc:hkm:wpaper:272009

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References

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  1. A pitfall of ageing
    by chris dillow in Stumbling and Mumbling on 2010-03-08 17:10:25
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Cited by:
  1. Joscha Beckmann & Ansgar Belke & Michael Kühl, 2009. "How Stable Are Monetary Models of the Dollar-Euro Exchange Rate?: A Time-Varying Coefficient Approach," Discussion Papers of DIW Berlin 944, DIW Berlin, German Institute for Economic Research.
  2. Philippe Bacchetta & Eric van Wincoop & Toni Beutler, 2009. "Can Parameter Instability Explain the Meese-Rogoff Puzzle?," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 09.08, Université de Lausanne, Faculté des HEC, DEEP.
  3. Joscha Beckmann & Ansgar Belke & Michael Kühl, 2011. "The dollar-euro exchange rate and macroeconomic fundamentals: a time-varying coefficient approach," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 147(1), pages 11-40, April.
  4. Waldyr Areosa & Marta Areosa, 2012. "The Signaling Effect of Exchange Rates: pass-through under dispersed information," Working Papers Series 282, Central Bank of Brazil, Research Department.
  5. Yutaka Kurihara, 2012. "Exchange rate determination and structural changes in response to monetary policies," Studies in Economics and Finance, Emerald Group Publishing, vol. 29(3), pages 187-196, August.

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