Exchange Rate Behaviour: Are Fundamentals Important?

One of the most controversial issues in the international economics literature concerns the role of economic fundamentals in explaining exchange rate behaviour. We interpret this controversy as having three different aspects. The first concerns the relationship between exchange rates and fundamentals in the 'long-run'. The second, the usefulness of fundamentals in producing out-of-sample forecasts which dominate a random walk, and the third controversy concerns the relative importance of shocks to real and nominal fundamentals in explaining real exchange rate variability (this, as we shall see, is related to the first). Controversies one and two, therefore, may be thought of as relating to the first moment of exchange rate behaviour, while the third is associated with the second moment. The first controversy may be motivated by referring to Fig. 1, which portrays the logarithm of the real and nominal exchange rates of the mark-dollar

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