The (Un-) Stable Relationship between The Exchange rate and its Fundamentals
This study investigates the relationship between the euro-dollar exchange rate and its underlying fundamentals by adopting non-linear time series modelling. We found that this relationship is episodically unstable. We also found that an equilibrium-distorting shock is likely to have a greater effect on the exchange rate during periods when the deviation between exchange rate and fundamentals is large; as a consequence, when the exchange rate is close to its equilibrium value it tends to be less sensitive to any shocks in the fundamentals.
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- Kilian, Lutz & Taylor, Mark P., 2001. "Why is it so difficult to beat the random walk forecast of exchange rates?," Working Paper Series 0088, European Central Bank.
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