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Non-linearities in the relation between the exchange rate and its fundamentals

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  • Carlo Altavilla

    (University of Naples, Italy)

  • Paul De Grauwe

    (Catholic University of Leuven, Belgium)

Abstract

We develop a simple theoretical model in which chartists and fundamentalists interact. The model predicts the existence of different regimes, and thus non-linearities in the link between the exchange rate and its fundamentals. We test the model empirically by adopting a Markov-switching vector error correction model. The results suggest the presence of non-linear mean reversion in the nominal exchange rate process. The implications are that different sets of macroeconomic fundamentals act as driving forces of the exchange rates during different time periods. Copyright © 2008 John Wiley & Sons, Ltd.

Suggested Citation

  • Carlo Altavilla & Paul De Grauwe, 2010. "Non-linearities in the relation between the exchange rate and its fundamentals," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 15(1), pages 1-21.
    • Handle: RePEc:ijf:ijfiec:v:15:y:2010:i:1:p:1-21
    DOI: 10.1002/ijfe.384
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    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • F31 - International Economics - - International Finance - - - Foreign Exchange

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