Exchange Rate Dynamics: Where is the Saddle Path?

A strand of exchange rate models postulate exchange rate fluctuations are driven by saddle-path dynamics and the related overshooting behavior. Using a bivariate system, the paper illustrates the relationship of the cointegration, saddle-path, and stationarity dynamics. Monte Carlo results indicate that the Johansen tests have reasonable power to discriminate saddle-path behavior from cointegration dynamics. Using monthly data from five major industrial countries, we find that exchange rates and prices are cointegrated. The cointegration result casts doubt on the use of saddle-path dynamics and the associated overshooting behavior to elucidate exchange rate variations.

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