The Response of Exchange Rates to Permanent and Transitory Shocks under Floating Exchange Rates

Traditional explanations of exchange-rate behavior have not fared well over the past two decades. Simple time series models have generally outperformed theoretically based models of exchange rates in forecasting nominal exchange rates during the floating-rate period. Movements in real and nominal exchange rates have been highly correlated. Perhaps most importantly, in all but a few instances, researchers have been unable to reject the hypothesis that real exchange rates have followed random walks during this period. As a consequence, purchasing power parity is now regarded by many, if not most, researchers as of virtually no use empirically. To explain exchange-rate movements under the float, there has been widespread resort to models in which real shocks play the dominant role…