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Non-Linearities in the Relation Between the Exchange Rate and its Fundamentals

39 Pages Posted: 7 Nov 2005  

Carlo Altavilla

European Central Bank (ECB)

Paul De Grauwe

London School of Economics & Political Science (LSE); CESifo (Center for Economic Studies and Ifo Institute for Economic Research); Centre for Economic Policy Research (CEPR)

Date Written: October 2005

Abstract

This paper investigates the relationship between the euro-dollar exchange rate and its underlying fundamentals. First, we develop a simple theoretical model in which chartists and fundamentalists interact. This model predicts the existence of different regimes, and thus non-linearities in the link between the exchange rate and its fundamentals. Second, we account for non-linearity in the exchange rate process by adopting a Markov-switching vector error correction model (MSVECM). Finally, the paper investigates the out-of-sample forecast performance of three competing models of exchange rate determination. The results suggest the presence of nonlinear mean reversion in the nominal exchange rate process. The implications are that different sets of macroeconomic fundamentals act as driving forces of the exchange rates during different time periods. More interestingly, the nonlinear specification significantly improves the forecast accuracy during periods when the deviation between exchange rate and fundamentals is large. Conversely, when the exchange rate is close to its equilibrium value it tends to be better approximated by a naïve random walk.

Keywords: non-linearity, Markov-switching model, fundamentals

JEL Classification: C32, F31

Suggested Citation

Altavilla, Carlo and De Grauwe, Paul, Non-Linearities in the Relation Between the Exchange Rate and its Fundamentals (October 2005). CESifo Working Paper Series No. 1561. Available at SSRN: https://ssrn.com/abstract=843405

Carlo Altavilla

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Paul De Grauwe (Contact Author)

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

CESifo (Center for Economic Studies and Ifo Institute for Economic Research)

Poschinger Str. 5
Munich, DE-81679
Germany

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

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