Long Swings in the Exchange Rate: are They in the Data and Do Markets Know it?

56 Pages Posted: 9 Jun 2004 Last revised: 27 Aug 2010

See all articles by Charles M. Engel

Charles M. Engel

University of Wisconsin - Madison - Department of Economics; National Bureau of Economic Research (NBER); University of Washington - Department of Economics

James D. Hamilton

University of California at San Diego; National Bureau of Economic Research (NBER)

Date Written: November 1989

Abstract

The value of the dollar appears to move in one direction for long periods of time. We develop a new statistical model of exchange rate dynamics as a sequence of stochastic, segmented time trends. The paper implements new techniques for parameter estimation and hypothesis testing for this framework. We reject the null hypothesis that exchange rates follow a random walk in favor of our model of long swings. Our model also generates better forecasts than a random walk. We conclude that persistent movement in the value of the dollar is a fact that calls for greater attention in the theory of exchange rate behavior. The model is a natural framework for assessing the importance of the "peso problem" for the dollar. It allows for the expectation of future exchange rates to be influenced by the probability of a change in regime. We nonetheless reject uncovered interest parity. The forward premium appears frequently to put too high a probability on a change in regime.

Suggested Citation

Engel, Charles M. and Hamilton, James D., Long Swings in the Exchange Rate: are They in the Data and Do Markets Know it? (November 1989). NBER Working Paper No. w3165. Available at SSRN: https://ssrn.com/abstract=227291

Charles M. Engel (Contact Author)

University of Wisconsin - Madison - Department of Economics ( email )

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University of Washington - Department of Economics ( email )

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James D. Hamilton

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