NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

On the Unstable Relationship between Exchange Rates and Macroeconomic Fundamentals

Philippe Bacchetta, Eric van Wincoop

NBER Working Paper No. 15008
Issued in May 2009
NBER Program(s):   AP   IFM

It is well known from anecdotal, survey and econometric evidence that the relationship between the exchange rate and macro fundamentals is highly unstable. This could be explained when structural parameters are known and very volatile, neither of which seems plausible. Instead we argue that large and frequent variations in the relationship between the exchange rate and macro fundamentals naturally develop when structural parameters in the economy are unknown and change very slowly. We show that the reduced form relationship between exchange rates and fundamentals is driven not by the structural parameters themselves, but rather by expectations of these parameters. These expectations can be highly unstable as a result of perfectly rational "scapegoat" effects. This happens when parameters can potentially change much more in the long run than the short run. This generates substantial uncertainty about the level of parameters, even though monthly or annual changes are small. This mechanism can also be relevant in other contexts of forward looking variables and could explain the widespread evidence of parameter instability found in macroeconomic and financial data. Finally, we show that parameter instability has remarkably little effect on the volatility of exchange rates, the in-sample explanatory power of macro fundamentals and the ability to forecast out of sample.

download in pdf format
   (655 K)

email paper

This paper is available as PDF (655 K) or via email.

A data appendix is available at http://www.nber.org/data-appendix/w15008

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w15008

Users who downloaded this paper also downloaded these:
Engel and West w10723 Exchange Rates and Fundamentals
Ball w15173 Policy Responses to Exchange-Rate Movements
Bacchetta and van Wincoop w10245 A Scapegoat Model of Exchange Rate Fluctuations
Berka and Devereux w15753 What Determines European Real Exchange Rates?
Chong, Jordà, and Taylor w15868 The Harrod-Balassa-Samuelson Hypothesis: Real Exchange Rates and their Long-Run Equilibrium
 
Publications
Activities
Meetings
NBER Videos
Data
People
About

Support
National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email: info@nber.org

Contact Us