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Exchange Rates and Macroeconomic Fundamentals: Evidence of Instabilities from Time-Varying Factor Loadings

Eric Hillebrand (), Jakob Mikkelsen (), Lars Spreng () and Giovanni Urga ()
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Jakob Mikkelsen: Danmarks Nationalbank, Postal: Danmarks Nationalbank, Havnegade 5, 1093 Copenhagen K, Denmark
Lars Spreng: Cass Business School, Postal: Centre for Econometric Analysis, Cass Business School, City, University of London, 106 Bunhill Row, London EC1Y 8TZ, UK

CREATES Research Papers from Department of Economics and Business Economics, Aarhus University

Abstract: We examine the relationship between exchange rates and macroeconomic fundamentals using a two-step maximum likelihood estimator through which we compute time-varying factor loadings. Factors are obtained as principal components, extracted from a large macro-dataset. Using 14 currencies over 1995–2018, we show that the loadings on the factors vary considerably over time with frequent sign changes. Allowing for time-varying loadings increases the percentage of explained variation in exchanges rates by an order of magnitude. Accounting for instabilities improves the predictive ability of the model globally and locally during crises, and yields better forecast of sign changes in exchange rates.

Keywords: foreign exchange rates; macroeconomic factors; time-varying loadings; high-dimensional factor models; exchange rate forecasting (search for similar items in EconPapers)
JEL-codes: C32 C38 C51 C52 C53 C55 F31 (search for similar items in EconPapers)
Pages: 42
Date: 2020-12-21
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