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Long Swings in the Exchange Rate: Are they in the Data and Do Markets Know It?

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Author Info
Charles Engel
James D. Hamilton

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Abstract

The value of the dollar appears to move in one direction for long periods of time. We develop a new statistical model of exchange rate dynamics as a sequence of stochastic, segmented time trends. The paper implements new techniques for parameter estimation and hypothesis testing for this framework. We reject the null hypothesis that exchange rates follow a random walk in favor of our model of long swings. Our model also generates better forecasts than a random walk. We conclude that persistent movement in the value of the dollar is a fact that calls for greater attention in the theory of exchange rate behavior. The model is a natural framework for assessing the importance of the "peso problem" for the dollar. It allows for the expectation of future exchange rates to be influenced by the probability of a change in regime. We nonetheless reject uncovered interest parity. The forward premium appears frequently to put too high a probability on a change in regime.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3165.

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Date of creation: Nov 1989
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Handle: RePEc:nbr:nberwo:3165

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References listed on IDEAS
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. Rudiger Dornbusch, 1986. "Flexible Exchange Rate and Excess Capital Mobility," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 17(1986-1), pages 209-235. [Downloadable!]
  2. Hamilton, James D., 1988. "Rational-expectations econometric analysis of changes in regime : An investigation of the term structure of interest rates," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 385-423. [Downloadable!] (restricted)
  3. Tauchen, George, 1985. "Diagnostic testing and evaluation of maximum likelihood models," Journal of Econometrics, Elsevier, vol. 30(1-2), pages 415-443. [Downloadable!] (restricted)
  4. Robert P. Flood & Peter M. Garber, 1983. "A Model of Stochastic Process Switching," NBER Working Papers 0626, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  5. repec:att:wimass:199520 is not listed on IDEAS
  6. Daniel, Betty C, 1989. "One-Sided Uncertainty about Future Fiscal Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 21(2), pages 176-89, May. [Downloadable!] (restricted)
  7. Frankel, Jeffrey A & Froot, Kenneth A, 1987. "Using Survey Data to Test Standard Propositions Regarding Exchange Rate Expectations," American Economic Review, American Economic Association, vol. 77(1), pages 133-53, March. [Downloadable!] (restricted)
  8. Robert E. Cumby & Maurice Obstfeld, 1984. "International Interest Rate and Price Level Linkages under Flexible Exchange Rates: A Review of Recent Evidence," NBER Chapters, in: Exchange Rate Theory and Practice, pages 121-152 National Bureau of Economic Research, Inc. [Downloadable!]
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  9. Diebold, Francis X. & Nason, James A., 1990. "Nonparametric exchange rate prediction?," Journal of International Economics, Elsevier, vol. 28(3-4), pages 315-332, May. [Downloadable!] (restricted)
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  10. Richard Meese & Kenneth Rogoff, 1982. "The out-of-sample failure of empirical exchange rate models: sampling error or misspecification?," International Finance Discussion Papers 204, Board of Governors of the Federal Reserve System (U.S.).
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  11. Watson, Mark W & Engle, Robert F, 1985. "Testing for Regression Coefficient Stability with a Stationary AR(1) Alternative," The Review of Economics and Statistics, MIT Press, vol. 67(2), pages 341-46, May. [Downloadable!] (restricted)
  12. Jeffrey A. Frankel & Saburo Okita & Peter G. Peterson & James R. Schlesinger, 1988. "International Capital Flows and Domestic Economic Policies," NBER Chapters, in: The United States in the World Economy, pages 559-658 National Bureau of Economic Research, Inc. [Downloadable!]
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  13. Martin S. Feldstein, 1986. "The Budget Deficit And The Dollar," NBER Chapters, in: NBER Macroeconomics Annual 1986, Volume 1, pages 355-409 National Bureau of Economic Research, Inc. [Downloadable!]
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  14. Mussa, Michael, 1986. "Nominal exchange rate regimes and the behavior of real exchange rates: Evidence and implications," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 25(1), pages 117-214, January. [Downloadable!] (restricted)
  15. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December. [Downloadable!] (restricted)
  16. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February. [Downloadable!] (restricted)
  17. Hodrick, Robert J. & Srivastava, Sanjay, 1984. "An investigation of risk and return in forward foreign exchange," Journal of International Money and Finance, Elsevier, vol. 3(1), pages 5-29, April. [Downloadable!] (restricted)
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  18. Lee, Lung-Fei & Chesher, Andrew, 1986. "Specification testing when score test statistics are identically zero," Journal of Econometrics, Elsevier, vol. 31(2), pages 121-149, March. [Downloadable!] (restricted)
  19. Jeffrey A. Frankel & Kenneth A. Froot, 1987. "Using Survey Data to Test Some Standard Propositions Regarding Exchange Rate Expectations," NBER Working Papers 1672, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  20. Mussa, Michael, 1979. "Empirical regularities in the behavior of exchange rates and theories of the foreign exchange market," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 11(1), pages 9-57, January. [Downloadable!] (restricted)
  21. Newey, Whitney K, 1985. "Maximum Likelihood Specification Testing and Conditional Moment Tests," Econometrica, Econometric Society, vol. 53(5), pages 1047-70, September. [Downloadable!] (restricted)
  22. Cochrane, John H, 1988. "How Big Is the Random Walk in GNP?," Journal of Political Economy, University of Chicago Press, vol. 96(5), pages 893-920, October. [Downloadable!] (restricted)
  23. Hamilton, James D., 1990. "Analysis of time series subject to changes in regime," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 39-70. [Downloadable!] (restricted)
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(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. Goldberg, M.D. & Frydman, R., 1995. "Imperfect Knowledge and Behavior in the Foreign Exchange Market," Working Papers 95-30, C.V. Starr Center for Applied Economics, New York University. [Downloadable!]
  2. Goldberg, Michael D. & Frydman, Roman, 1991. "Re-examining the Empirical Performance of the Monetary Models of the Exchange Rate: A Problem of Structural Change," Working Papers 91-69, C.V. Starr Center for Applied Economics, New York University. [Downloadable!]
  3. Frydman, R. & Goldberg, M.D., 2003. "Imperfect Knowledge and Asset Price Dynamics: Modeling the Forecasting of Rational Agents, Dynamic Prospect Theory and Uncertainty Premia on Foreign Exchange," Working Papers 03-03, C.V. Starr Center for Applied Economics, New York University. [Downloadable!]
  4. Kenneth S. Rogoff & Vania Stavrakeva, 2008. "The Continuing Puzzle of Short Horizon Exchange Rate Forecasting," NBER Working Papers 14071, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  5. Maurice Peat & Max Stevenson, 1995. "Testing for Nonlinearities in Economic and Financial Time Series," Working Paper Series 48, School of Finance and Economics, University of Technology, Sydney. [Downloadable!]
  6. Yin-Wong Cheung & Menzie Chinn & Antonio Garcia Pascual, 2003. "Empirical Exchange Rate Models of the Nineties: Are Any Fit to Survive?," Santa Cruz Department of Economics, Working Paper Series 1033, Department of Economics, UC Santa Cruz. [Downloadable!]
    Other versions:
  7. Roman Frydman & Michael D. Goldberg, 2003. "Imperfect Knowledge and Asset Price Dynamics: Modeling the Forecasting of Rational Agents, Dynamic Prospect Theory and Uncertainty Premia on Foreign Exchange," Discussion Papers 03-31, University of Copenhagen. Department of Economics. [Downloadable!]
  8. Yin-Wong Cheung & Menzie Chinn & Antonio Garcia Pascual, 2003. "What Do We Know about Recent Exchange Rate Models? In-Sample Fit and Out-of-Sample Performance Evaluated," Santa Cruz Center for International Economics, Working Paper Series 1010, Center for International Economics, UC Santa Cruz. [Downloadable!]
    Other versions:
  9. Goldberg, M.D. & Frydman, R., 1993. "Empirical Exchange Rate Models and Shifts in the Co-Integrating Vector," Working Papers 93-41, C.V. Starr Center for Applied Economics, New York University. [Downloadable!]
  10. Roman Frydman & Michael D. Goldberg & Søren Johansen & Katarina Juselius, 2009. "A Resolution of the Purchasing Power Parity Puzzle: Imperfect Knowledge and Long Swings," CREATES Research Papers 2009-01, School of Economics and Management, University of Aarhus. [Downloadable!]
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  11. Michael D. Goldberg & Roman Frydman, 2001. "Macroeconomic Fundamentals and the DM/$ Exchange Rate: Temporal Instability and the Monetary Model," Working Papers 50, Oesterreichische Nationalbank (Austrian Central Bank). [Downloadable!]
  12. Yangru Wu, 1996. "Mean Reversion In Equilibrium Real Exchange Rates," International Economic Journal, Korean International Economic Association, vol. 10(2), pages 85-104, June. [Downloadable!] (restricted)
  13. Roman Frydman & Michael D. Goldberg, 2002. "Imperfect Knowledge, Temporal Instability and an Uncertainty Premium: Towards a Resolution of the Excess-Returns Puzzle in the Foreign Exchange Market," Discussion Papers 02-17, University of Copenhagen. Department of Economics, revised Nov 2002. [Downloadable!]
  14. Simon van Norden, 1995. "Regime Switching as a Test for Exchange Rate Bubbles," Econometrics 9502001, EconWPA, revised 09 Aug 1995. [Downloadable!]
    Other versions:
  15. Jeffrey A. Frankel & Kenneth Froot, 1990. "Exchange Rate Forecasting Techniques, Survey Data, and Implications for the Foreign Exchange Market," NBER Working Papers 3470, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
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