Currency and Competitiveness in Europe
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Currency and Competitiveness in Europe

Edited by Klaus Liebscher, Josef Christl, Peter Mooslechner and Doris Ritzberger-Grünwald

This book combines currency matters with competitiveness considerations, with a view to raising the understanding of exchange rate dynamics and to analysing the role of exchange rates in reinforcing economic competitiveness.
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Chapter 7: Macroeconomic Fundamentals and the Exchange Rate

Ronald MacDonald


Ronald MacDonald1 INTRODUCTION 7.1 There is a widespread perception in the economics profession that exchange rates are disconnected from macroeconomic fundamentals and this can be illustrated using two puzzles in international finance, namely the levels puzzle and the volatility puzzle. In this chapter we consider these puzzles and argue that they really aren’t so puzzling after all. Our main conclusion is that macro fundamentals are important determinants of exchange rates, that they can explain exchange rate volatility, and that they can also be used to provide exchange rate forecasts that dominate a random-walk at even short horizons. The levels puzzle was generated initially by Meese and Rogoff (1983), who demonstrated that macroeconomic-based models of the exchange rate were unable to outperform a random-walk in an out-of-sample forecasting context. For many years, this result has seemed almost impossible to overturn and it has become something of a stylized fact that the predictability of exchange rates, in terms of macro fundamentals, only kicks in at ‘long’ horizons (horizons of three years or greater); forecasting exchange rates at shorter horizons is therefore something of a futile exercise (Frankel and Rose, 1995 and Rogoff, 1999). In this chapter we argue that this stylized result reflects the use of inappropriate estimation methods rather than the inappropriateness of macro fundamentals. The volatility puzzle has inter- and intra-regime dimensions. In terms of inter-regime volatility, the perception is that in moving from fixed to floating exchange rates the volatility of macro fundamentals stays unchanged, but the volatility...

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