Exchange Rate Dynamics and Forecast Errors about Persistently Trending Fundamentals

Josh Stillwagon ()
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Josh Stillwagon: Department of Economics, Trinity College

No 1501, Working Papers from Trinity College, Department of Economics

Abstract: This paper offers and tests a unique explanation for the exchange rate determination puzzle. It is not that exchange rates are unrelated to fundamentals, but rather when fundamentals undergo persistent changes it becomes important to measure their effect in terms of how they change relative to what was expected. This result is demonstrated with a simple present discounted value model of the exchange rate and then tested for four USD exchange rates using interest rate forecast data from nearly 50 major banks. Using the polynomially cointegrated VAR, or I(2) CVAR, the interest rate forecast errors are found to have a large and statistically significant impact on the exchange rate even independent of the level and change in the relative interest rate (with t-values in the double digits for all four samples). Further, this effect is greater in the samples with stronger evidence of persistent changes in the interest rate differential.

Keywords: Exchange Rates; Determination Puzzle; Survey Data; Forecast Errors; I(2) Cointegration (search for similar items in EconPapers)
JEL-codes: F31 G12 G15 (search for similar items in EconPapers)
Pages: 41 pages
Date: 2015-02
New Economics Papers: this item is included in nep-cba, nep-for, nep-mon and nep-opm
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http://www3.trincoll.edu/repec/WorkingPapers2015/WP15-01.pdf First version, 2015 (application/pdf)

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Persistent link: https://EconPapers.repec.org/RePEc:tri:wpaper:1501

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