DP6638 Exchange Rates and Fundamentals: Footloose or Evolving Relationship?

Author(s): Lucio Sarno , Giorgio Valente

Publication Date: January 2008

Keyword(s): economic fundamentals , exchange rates , forecasting

JEL(s): F31 , G10

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP6638.asp

Using novel real-time data on a broad set of economic fundamentals for five major US dollar exchange rates over the recent float, we employ a predictive procedure that allows the relationship between exchange rates and fundamentals to evolve over time in a very general fashion. Our key findings are that: (i) the well-documented weak out-of-sample predictive ability of exchange rate models may be caused by poor performance of model-selection criteria, rather than lack of information content in the fundamentals; (ii) the difficulty of selecting the best predictive model is largely due to frequent shifts in the set of fundamentals driving exchange rates, which can be interpreted as reflecting swings in market expectations over time. However, the strength of the link between exchange rates and fundamentals is different across currencies.