Exchange Rates and Fundamentals a Non-Linear Relationship?

39 Pages Posted: 30 Oct 2001

See all articles by Paul De Grauwe

Paul De Grauwe

London School of Economics & Political Science (LSE); CESifo (Center for Economic Studies and Ifo Institute for Economic Research); Centre for Economic Policy Research (CEPR)

Isabel Vansteenkiste

European Central Bank (ECB)

Date Written: October 2001

Abstract

We test whether the relationship between the nominal exchange rate and the news in its underlying fundamentals has non-linear features. In order to do so, we develop a Markov switching model and apply it to 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 two non-linear models that are capable of explaining our empirical findings. A first model is based on the existence of transaction costs; a second one assumes the existence of agents using different information to forecast the future exchange rate. In both cases we find that these simple non-linear models are capable of replicating the empirical evidence uncovered in this paper.

JEL Classification: F31, F37

Suggested Citation

De Grauwe, Paul and Vansteenkiste, Isabel, Exchange Rates and Fundamentals a Non-Linear Relationship? (October 2001). Available at SSRN: https://ssrn.com/abstract=287677

Paul De Grauwe (Contact Author)

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

CESifo (Center for Economic Studies and Ifo Institute for Economic Research)

Poschinger Str. 5
Munich, DE-81679
Germany

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Isabel Vansteenkiste

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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