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Exchange Rate Dynamics and Forecast Errors about Persistently Trending Fundamentals

Author

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  • Josh R. Stillwagon

    (Department of Economics, Trinity College)

Abstract

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.

Suggested Citation

  • Josh R. Stillwagon, 2015. "Exchange Rate Dynamics and Forecast Errors about Persistently Trending Fundamentals," Working Papers 1501, Trinity College, Department of Economics.
    • Handle: RePEc:tri:wpaper:1501
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    File URL: http://www3.trincoll.edu/repec/WorkingPapers2015/WP15-01.pdf
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    More about this item

    Keywords

    Exchange Rates; Determination Puzzle; Survey Data; Forecast Errors; I(2) Cointegration;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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