TY  - JOUR
AU  - Bacchetta,Philippe
AU  - Wincoop,Eric van
TI  - On the Unstable Relationship between Exchange Rates and Macroeconomic Fundamentals
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 15008
PY  - 2009
Y2  - May 2009
UR  - http://www.nber.org/papers/w15008
L1  - http://www.nber.org/papers/w15008.pdf
N1  - Author contact info:
Philippe Bacchetta
Faculty of Business and Economics
University of Lausanne
Extranef
CH-1015 Lausanne
Switzerland
E-Mail: philippe.bacchetta@unil.ch

Eric van Wincoop
Department of Economics
University of Virginia
P.O. Box 400182
Charlottesville, VA  22904-4182
Tel: 434/924-3997
Fax: 434/982-2904
E-Mail: vanwincoop@virginia.edu
AB  - 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.
ER  -