Exchange rate determination : Is there a role for macroeconomic fundamentals?

Abstract

A review of recent literature shows that the application of co-integration techniques and the use of larger data sets have led to more empirical evidence in favour of both the Purchasing Power Parity and the monetary approach to exchange rate determination as long-run relationships. 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. Target zone arrangements appear to have only a small effect, if any, on exchange rates. A merger of the macroeconomic approach with microeconomic factors may be a fruitful direction to explain short-run behaviour.