Working Paper: NBER ID: w15008
Authors: Philippe Bacchetta; Eric Van Wincoop
Abstract: It is well known from anecdotal, survey and econometric evidence that the relationship between the exchange rate and macro fundamentals is highly unstable. This could be explained when structural parameters are known and very volatile, neither of which seems plausible. Instead we argue that large and frequent variations in the relationship between the exchange rate and macro fundamentals naturally develop when structural parameters in the economy are unknown and change very slowly. We show that the reduced form relationship between exchange rates and fundamentals is driven not by the structural parameters themselves, but rather by expectations of these parameters. These expectations can be highly unstable as a result of perfectly rational "scapegoat" effects. This happens when parameters can potentially change much more in the long run than the short run. This generates substantial uncertainty about the level of parameters, even though monthly or annual changes are small. This mechanism can also be relevant in other contexts of forward looking variables and could explain the widespread evidence of parameter instability found in macroeconomic and financial data. Finally, we show that parameter instability has remarkably little effect on the volatility of exchange rates, the in-sample explanatory power of macro fundamentals and the ability to forecast out of sample.
Keywords: exchange rates; macroeconomic fundamentals; parameter instability; scapegoat effects
JEL Codes: F31; F37; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| expectations of structural parameters (C51) | unstable relationship between exchange rates and macro fundamentals (F31) |
| expectations of structural parameters (C51) | significant instability in the reduced-form relationship (C51) |
| rational expectations and learning processes among agents (D84) | instability in the relationship between exchange rates and macro fundamentals (F31) |
| expectations of parameters (C51) | large and frequent variations in the relationship between exchange rates and macro fundamentals (F31) |
| rational scapegoat effects (C92) | fluctuations in exchange rates attributed to observed macro fundamentals (F31) |
| parameter instability (C62) | minimal effect on exchange rate volatility (F31) |
| parameter instability (C62) | minimal effect on explanatory power of macro fundamentals (E19) |
| parameter instability (C62) | minimal effect on out-of-sample forecasting ability (C53) |