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Are Exchange Rates Excessively Variable?

In: NBER Macroeconomics Annual 1987, Volume 2

  • Jeffrey A. Frankel
  • Richard Meese

"Unnecessary variation" is defined as variation not attributable to variation in fundamentals. In the absence of a good model of macroeconomic fundamentals, the question "are exchange rates excessively variable?" cannot be answered by comparing the variance of the actual exchange rate to the variance of a set of fundamentals. This paper notes the failure of regression equations to explain exchange rate movements even using contemporaneous macroeconomic variables. It notes as well the statistical rejections of the unbiasedness of the forward exchange rate as a predictor of the spot rate. It then argues that, given these results, there is not much to be learned from the variance-bounds tests and bubbles tests. The paper also discusses recent results on variation in the exchange risk premiums arising from variation in conditional variances, both as a source of the bias in the forward rate tests and as a source of variation in the spot rate. It finishes with a discussion of whether speculators' expectations are stabilizing or destabilizing, as measured by survey data. The paper concludes that it is possible that exchange rates have been excessively variable -- as, for example, when there are speculative bubbles -- but that if policy-makers try systematically to exploit their credibility in order to stabilize exchange rates, they may see their current credibility vanish.

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This chapter was published in:
  • Stanley Fischer, 1987. "NBER Macroeconomics Annual 1987, Volume 2," NBER Books, National Bureau of Economic Research, Inc, number fisc87-1, October.
  • This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 11100.
    Handle: RePEc:nbr:nberch:11100
    Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
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    1. Minford, Patrick & Marwaha, Satwant & Matthews, Kent & Sprague, Alison, 1984. "The Liverpool macroeconomic model of the United Kingdom," Economic Modelling, Elsevier, vol. 1(1), pages 24-62, January.
    2. Salmon, Mark & Wallis, Kenneth F, 1980. "Model Validation and Forecast Comparisons : Theoretical and Practical Considerations," The Warwick Economics Research Paper Series (TWERPS) 184, University of Warwick, Department of Economics.
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