Working Paper: CEPR ID: DP9472
Authors: Lucio Sarno; Maik Schmeling
Abstract: Standard present-value models suggest that exchange rates are driven by expected future fundamentals, implying that exchange rates contain information about future fundamentals. We test this key empirical prediction of present-value models in a sample of 35 currency pairs ranging from 1900 to 2009. Employing a variety of tests, we find that exchange rates have strong and significant predictive power for nominal fundamentals (inflation, money balances, nominal GDP), whereas predictability of real fundamentals and risk premia is much weaker and largely confined to the post-Bretton Woods era. Overall, we uncover ample evidence that future macro fundamentals drive current exchange rates.
Keywords: economic fundamentals; exchange rates; forecasting; present value model
JEL Codes: F31; G10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| past exchange rate movements (F31) | future nominal fundamentals (E66) |
| appreciating currencies (F31) | lower future inflation rates (E31) |
| appreciating currencies (F31) | reduced money growth (E49) |
| appreciating currencies (F31) | lower nominal GDP growth (O49) |
| exchange rates (F31) | future macro fundamentals (E66) |
| current exchange rates (F31) | future macro fundamentals (E66) |