Are Exchange Rates Really Random Walks? Some Evidence Robust To Parameter Instability
Abstract
Many authors have documented that it is challenging to explain exchange rate fluctuations
with macroeconomic fundamentals: a random walk forecasts future exchange rates better
than existing macroeconomic models. This paper applies newly developed tests for nested
model that are robust to the presence of parameter instability. The empirical evidence
shows that for some countries we can reject the hypothesis that exchange rates are
random walks. This raises the possibility that economic models were previously rejected
not because the fundamentals are completely unrelated to exchange rate fluctuations,
but because the relationship is unstable over time and, thus, difficult to capture
by Granger Causality tests or by forecast comparisons. We also analyze forecasts that
exploit the time variation in the parameters and find that, in some cases, they can
improve over the random walk.
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