On the dynamic relationship of exchange rates and monetary fundamentals: an impulse-response analysis by local projections

Abstract

Meese and Rogoff (1983) first examined the dynamic relationship between exchange rates and monetary fundamentals and indicated that monetary fundamentals do not contain predictive component of exchange rates changes at short horizon. This note re-examines this relationship by estimating the local projections (Jorda, 2005) to calculate the responses of the exchange rate to monetary fundamental impulse. As a result, we confirm the dynamic relationship: Evidence from both cubic and linear projections show that monetary fundamentals contain information of future exchange rate changes.

Acknowledgements

This article is a brief version of a research project financially sponsored by the National Science Committee of Taiwan (NSC 94–2415–H–128–002–).

Notes

¹ Taylor (1995) provided an excellent survey.

² Small letters denote natural logarithm.

³ To evaluate whether fundamental Granger causes exchange rates, Engel and West (2005) estimated the following VAR, and calculated the Wald statistic for Granger causality.

⁴ Period-average rates give the same results, which are saved in this article, but are available from the author.