Discussion Paper Details

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Title: Monetary Fundamentals and Exchange Rate Dynamics under Different Nominal Regimes

Author(s): Lucio Sarno, Giorgio Valente and Mark E Wohar

Publication Date: July 2003

Keyword(s): foreign exchange, monetary fundamentals, non-linearity and regime switching

Programme Area(s): International Macroeconomics

Abstract: We investigate the dynamic relationship between the US dollar exchange rate and its fundamentals across different exchange rate regimes using data going back to the late 1800s or early 1900s for six industrialized countries. For these countries there is evidence of a long-run relation between the nominal exchange rate and monetary fundamentals consistent with conventional theories of exchange rate determination. We employ a Markov-switching vector equilibrium correction model that allows for regime shifts in the entire set of parameters and the variance-covariance matrix. Our results suggest that the relative importance of exchange rates and fundamentals in restoring the long-run equilibrium level implied by the exchange rate-monetary fundamentals model varies significantly over time and is affected by the nominal exchange rate regime in operation.

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Bibliographic Reference

Sarno, L, Valente, G and Wohar, M. 2003. 'Monetary Fundamentals and Exchange Rate Dynamics under Different Nominal Regimes'. London, Centre for Economic Policy Research.