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Which Fundamentals Drive Exchange Rates? A Cross-Sectional Perspective

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  • Sarno, Lucio
  • Schmeling, Maik

Abstract

Standard present-value models suggest that exchange rates are driven by expected future fundamentals, implying that exchange rates contain information about future fundamentals. We test this key empirical prediction of present-value models in a sample of 35 currency pairs ranging from 1900 to 2009. Employing a variety of tests, we find that exchange rates have strong and significant predictive power for nominal fundamentals (inflation, money balances, nominal GDP), whereas predictability of real fundamentals and risk premia is much weaker and largely confined to the post-Bretton Woods era. Overall, we uncover ample evidence that future macro fundamentals drive current exchange rates.

Suggested Citation

  • Sarno, Lucio & Schmeling, Maik, 2013. "Which Fundamentals Drive Exchange Rates? A Cross-Sectional Perspective," CEPR Discussion Papers 9472, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:9472
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    More about this item

    Keywords

    Exchange rates; Economic fundamentals; Forecasting; Present value model;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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