DP9472 Which Fundamentals Drive Exchange Rates? A Cross-Sectional Perspective

Author(s): Lucio Sarno, Maik Schmeling
Publication Date: May 2013
Keyword(s): economic fundamentals, Exchange rates, forecasting, present value model
JEL(s): F31, G10
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9472

Standard present-value models suggest that exchange rates are driven by expected future fundamentals, implying that exchange rates contain information about future fundamentals. We test this key empirical prediction of present-value models in a sample of 35 currency pairs ranging from 1900 to 2009. Employing a variety of tests, we find that exchange rates have strong and significant predictive power for nominal fundamentals (inflation, money balances, nominal GDP), whereas predictability of real fundamentals and risk premia is much weaker and largely confined to the post-Bretton Woods era. Overall, we uncover ample evidence that future macro fundamentals drive current exchange rates.