Exchange Rates, Fundamentals, and Nonlinearities: A Review and Some Further Evidence from a Century of Data
Macroeconomic Analysis and International Finance
ISBN: 978-1-78350-755-9, eISBN: 978-1-78350-756-6
Publication date: 26 April 2014
Abstract
Purpose
The purpose of this paper is to provide an extensive review of the monetary model of exchange rate determination which is the main theoretical framework on analyzing exchange rate behavior over the last 40 years. Furthermore, we test the flexible price monetarist variant and the sticky price Keynesian variant of the monetary model. We conduct our analysis employing a sample of 14 advanced economies using annual data spanning the period 1880–2012.
Design/methodology/approach
The theoretical background of the paper relies on the monetary model to the exchange rate determination. We provide a thorough econometric analysis using a battery of unit root and cointegration testing techniques. We test the price-flexible monetarist version and the sticky-price version of the model using annual data from 1880 to 2012 for a group of industrialized countries.
Findings
We provide strong evidence of the existence of a nonlinear relationship between exchange rates and fundamentals. Therefore, we model the time-varying nature of this relationship by allowing for Markov regime switches for the exchange rate regimes. Modeling exchange rates within this context can be motivated by the fact that the change in regime should be considered as a random event and not predictable. These results show that linearity is rejected in favor of an MS-VECM specification which forms statistically an adequate representation of the data. Two regimes are implied by the model; the one of the estimated regimes describes the monetary model whereas the other matches in most cases the constant coefficient model with wrong signs. Furthermore it is shown that depending on the nominal exchange rate regime in operation, the adjustment to the long run implied by the monetary model of the exchange rate determination came either from the exchange rate or from the monetary fundamentals. Moreover, based on a Regime Classification Measure, we showed that our chosen Markov-switching specification performed well in distinguishing between the two regimes for all cases. Finally, it is shown that fundamentals are not only significant within each regime but are also significant for the switches between the two regimes.
Practical implications
The results are of interest to practitioners and policy makers since understanding the evolution and determination of exchange rates is of crucial importance. Furthermore, our results are linked to forecasting performance of exchange rate models.
Originality/value
The present analysis extends previous analyses on exchange rate determination and it provides further support in favor of the monetary model as a long-run framework to understand the evolution of exchange rates.
Keywords
Acknowledgements
Acknowledgments
An earlier version of this paper was presented at the 17th International Conference on Macroeconomic Analysis and International Finance, Rethymno, May 30–June 1, 2013 and thanks are due to conference participants for many helpful comments and discussions. The third author acknowledges financial support by a Marie Curie Transfer of Knowledge Fellowship of the European Community’s Sixth Framework Programme under contract number MTKD-CT-014288 as well as from the Research Committee of the University of Crete under research grant #2257. We thank Philippe Bacchetta, Richard Baillie, Michael Bordo, Dimitris Georgoutsos, Paul De Grauwe, Katarina Juselius, Menelaos Karanasos, Jim Lothian, Mike Melvin, Lucio Sarno, Dimitris Thomakos, and Mark Wohar for many helpful comments and discussions. We also thank Michael Bordo and Mark Wohar for generously providing the data used in this paper. Theodoros Bratis, Ioannis Polykarpou, and Evangelos Salachas provided superb research assistance. The usual caveat applies.
Citation
Diamandis, P.F., Drakos, A.A. and Kouretas, G.P. (2014), "Exchange Rates, Fundamentals, and Nonlinearities: A Review and Some Further Evidence from a Century of Data", Macroeconomic Analysis and International Finance (International Symposia in Economic Theory and Econometrics, Vol. 23), Emerald Group Publishing Limited, Leeds, pp. 85-124. https://doi.org/10.1108/S1571-038620140000023004
Publisher
:Emerald Group Publishing Limited
Copyright © 2014 Emerald Group Publishing Limited