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Exchange Rate Dynamics and Forecast Errors about Persistently Trending Fundamentals

Listed author(s):
  • Josh R. Stillwagon

    ()

    (Department of Economics, Trinity College)

This paper offers and tests a unique explanation for the exchange rate determination puzzle. It is not that exchange rates are unrelated to fundamentals, but rather when fundamentals undergo persistent changes it becomes important to measure their effect in terms of how they change relative to what was expected. This result is demonstrated with a simple present discounted value model of the exchange rate and then tested for four USD exchange rates using interest rate forecast data from nearly 50 major banks. Using the polynomially cointegrated VAR, or I(2) CVAR, the interest rate forecast errors are found to have a large and statistically significant impact on the exchange rate even independent of the level and change in the relative interest rate (with t-values in the double digits for all four samples). Further, this effect is greater in the samples with stronger evidence of persistent changes in the interest rate differential.

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File URL: http://internet2.trincoll.edu/repec/WorkingPapers2015/WP15-01.pdf
File Function: First version, 2015
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Paper provided by Trinity College, Department of Economics in its series Working Papers with number 1501.

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Length: 41 pages
Date of creation: Feb 2015
Handle: RePEc:tri:wpaper:1501
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Web page: http://www.trincoll.edu/Academics/MajorsAndMinors/Economics/Pages/default.aspx

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