Exchange-rate determination : is there a role for macroeconomic fundamentals?
Nijmegen : Catholic University of Nijmegen, Faculty of Policy Sciences, Department of Applied economics
Working Paper ; 97.01
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This paper reviews recent trends in exchange rate modelling with a view toward assessing new claims that macroeconomic variables are useful for explaining exchange rates. The application to co-integration techniques and the use of larger datasets have led to more empirical evidence in favour of both the puchasing power parity and the monetary approach to exchange rate determination as long-fun relationships. Various studies show that the forecasts based on variables suggested by the monetary approach outperform the random walk. It is questionable, however, whether the tests used validate the monetary approach of exchange rate determination or just show that macroeconomic variables have a role to play. Extensions of the basic target-zone model and empirical evidence reveal that the relation between economic fundamentals and exchange rates is much less influenced by the target-zone arrangement than Krugman originally suggested. A merger of the macroeconomic approach with microeconomic factors may be a fruitful direction for explaining short-sun behavior.
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