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Non‐linearities in the relation between the exchange rate and its fundamentals
Author(s) -
Altavilla Carlo,
De Grauwe Paul
Publication year - 2010
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.384
Subject(s) - exchange rate , economics , econometrics , error correction model , mean reversion , markov chain , simple (philosophy) , cointegration , mathematics , monetary economics , statistics , philosophy , epistemology
We develop a simple theoretical model in which chartists and fundamentalists interact. The model predicts the existence of different regimes, and thus non‐linearities in the link between the exchange rate and its fundamentals. We test the model empirically by adopting a Markov‐switching vector error correction model. The results suggest the presence of non‐linear mean reversion in the nominal exchange rate process. The implications are that different sets of macroeconomic fundamentals act as driving forces of the exchange rates during different time periods. Copyright © 2008 John Wiley & Sons, Ltd.