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Exchange rates and fundamentals: a non‐linear relationship?
Author(s) -
De Grauwe Paul,
Vansteenkiste Isabel
Publication year - 2007
Publication title -
international journal of finance and economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.505
H-Index - 39
eISSN - 1099-1158
pISSN - 1076-9307
DOI - 10.1002/ijfe.310
Subject(s) - economics , econometrics , inflation (cosmology) , exchange rate , markov chain , linear model , empirical research , sample (material) , empirical evidence , order (exchange) , monetary economics , mathematics , statistics , thermodynamics , philosophy , physics , epistemology , finance , theoretical physics
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. Copyright © 2007 John Wiley & Sons, Ltd.