Working Paper: CEPR ID: DP3983
Authors: Lucio Sarno; Giorgio Valente; Mark E. Wohar
Abstract: We investigate the dynamic relationship between the US dollar exchange rate and its fundamentals across different exchange rate regimes using data going back to the late 1800s or early 1900s for six industrialized countries. For these countries there is evidence of a long-run relation between the nominal exchange rate and monetary fundamentals consistent with conventional theories of exchange rate determination. We employ a Markov-switching vector equilibrium correction model that allows for regime shifts in the entire set of parameters and the variance-covariance matrix. Our results suggest that the relative importance of exchange rates and fundamentals in restoring the long-run equilibrium level implied by the exchange rate-monetary fundamentals model varies significantly over time and is affected by the nominal exchange rate regime in operation.
Keywords: foreign exchange; monetary fundamentals; nonlinearity; regime switching
JEL Codes: F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Monetary fundamentals (E50) | Long-run equilibrium (D59) |
| Nominal exchange rate (F31) | Long-run equilibrium (D59) |
| Fixed exchange rate regime (F33) | Monetary fundamentals (E50) |
| Floating exchange rate regime (F33) | Nominal exchange rate (F31) |
| Exchange rate regime (F33) | Adjustment mechanisms (F32) |