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Exchange rates and fundamentals: a non-linear relationship?

de Grauwe, Paul and Vansteenkiste, Isabel (2007) Exchange rates and fundamentals: a non-linear relationship? International Journal of Finance and Economics, 12 (1). pp. 37-54. ISSN 1076-9307

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Identification Number: 10.1002/ijfe.310


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.

Item Type: Article
Official URL:
Additional Information: © 2007 John wiley & Sons
Divisions: LSE
Subjects: H Social Sciences > HB Economic Theory
H Social Sciences > HG Finance
JEL classification: F - International Economics > F3 - International Finance > F31 - Foreign Exchange
F - International Economics > F3 - International Finance > F37 - International Finance Forecasting and Simulation
Date Deposited: 05 Oct 2012 12:49
Last Modified: 20 Jul 2021 23:09

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