Exchange Rates and Fundamentals: A Non-Linear Relationship?

Paul De Grauwe and Isabel Vansteenkiste

Chapter 5 in Exchange Rates and Global Financial Policies, 2014, pp 159-187 from World Scientific Publishing Co. Pte. Ltd.

Abstract: We test whether the relationship between changes in the nominal exchange rate and changes in its underlying fundamentals has non-linear features. In order to do so, we extend the Markov-switching model as proposed by McConnell and Perez Quiros (2000) and Dewachter (2001) and test it using a sample of low-and high-inflation countries. The empirical analysis shows that for the high-inflation countries the relationship between news in the fundamentals and the exchange rate changes is stable and significant. This is not the case, however, for the low-inflation countries, where frequent regime switches occur. We develop a non-linear model based on the existence of transactions costs that could explain our empirical findings. We find that this simple non-linear model is capable of replicating the empirical evidence uncovered in this paper.

Keywords: Exchange Rate; Financial Policies; Turbulence; Exchange Market; Motenary Union; Macroeconomics; Economic Models; Behaviorial Economics; Monetary Integration; Euro; Financial Crisis; European Monetary Policy; Dynamic Stochastic General Equilibriumauthor (search for similar items in EconPapers)
Date: 2014
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Related works:
Journal Article: Exchange rates and fundamentals: a non-linear relationship? (2007)
Working Paper: Exchange Rates and fundamentals - a Non-Linear Relationship? (2001)
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