Working Paper: NBER ID: w3165
Authors: Charles Engel; James D. Hamilton
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.
Keywords: exchange rates; stochastic trends; uncovered interest parity
JEL Codes: F31; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| long swings in the exchange rate (F31) | significant feature of the data-generating process (C51) |
| probabilities of regime changes (P27) | expected changes in exchange rates during different regimes (F31) |
| regime 1 (P30) | German mark appreciates by 4% per quarter (F31) |
| regime 1 (P30) | franc appreciates by 3.3% per quarter (F31) |
| regime 1 (P30) | pound appreciates by 2.6% per quarter (F31) |
| regime 2 (P30) | German mark depreciates by 1.2% (F31) |
| regime 2 (P30) | franc depreciates by 2.7% (F31) |
| regime 2 (P30) | pound depreciates by 3.8% (F31) |
| segmented trends model (C32) | significant reduction in forecast error compared to random walk (C53) |
| uncovered interest parity fails (F31) | markets may not accurately forecast future exchange rates (F31) |