Faculty of Economics and Business Administration Publications Database

Which Fundamentals Drive Exchange Rates? A Cross‐Sectional Perspective

Sarno, Lucio
Volume: 46
Number: 2-3
Pages: 267 - 292
Month: March-April
ISSN-Print: 0022-2879
Link External Source: Online Version
Year: 2014
Keywords: Exchange rates; economic fundamentals; forecasting; present value model

Standard present‐value models suggest that exchange rates are driven by expected future fundamentals, implying that exchange rates contain information about future fundamentals. We test this key empirical prediction of present‐value models in a sample of 35 currency pairs ranging from 1900 to 2009. Employing a variety of tests, we find that exchange rates have strong and significant predictive power for nominal fundamentals (inflation, money balances, nominal GDP), whereas predictability of real fundamentals and risk premia is much weaker and largely confined to the post–Bretton Woods era. Overall, we uncover ample evidence that future macrofundamentals drive current exchange rates.