Exchange Rate Economics: Theories and Evidence

20 Introduction
(mean and variance) of exchange rates and the so-called exchange rate disconnect
which relates to both the mean and variance of the exchange rate.
1.8.1 The level, or first moment, of the exchange rate and
the exchange rate disconnect
It has become something of a stylised fact for financial markets that the unconditional
price,or return,distributions of financial assets tend to have fatter tails
than the normal distribution. In contrast to the thin-tailed normal distribution,
in which the tails decline exponentially,fat-tailed asset market returns decline
by a power factor. The so-called fat-tailed result has been confirmed for foreign
exchange rates by Westerfield (1977) and Boothe and Glassman (1987) using parametric
methods and Koedijk et al. (1990) using semi-parametric methods. De Vries
(1994) notes that this fat-tailed phenomenon is more pronounced when exchange
rates are managed than in a pure float and he further notes that exchange rate
returns of currencies which experience similar monetary policies exhibit no significant
skewness while those with dissimilar polices tend to exhibit skewness (this
being most marked in instances where one country is pursuing deflationary policies
while its partner is pursuing inflationary monetary policy). 11
Nominal,and also real,exchange rates,as we shall see in Chapters 3 and 4,
are generally regarded as stochastic process containing a unit root; that is,they
are I (1) processes. Since the standard range of macroeconomic fundamentals
also contain unit roots this has led to most recent empirical analysis of the
determinants of the level of nominal exchange rate using non-stationary time
series methods,such as cointegration analysis (this is discussed in some detail in
Chapter 6).
One of the key themes considered in this book is the so-called exchange rate
disconnect of Obstfeld and Rogoff (2000a). This disconnect shows up in two ways.
The first is that discussed in the next section and concerns the apparent lack of
connection between the volatility of exchange rate fundamentals and the volatility
of the underlying macroeconomic fundamentals. The second is in terms of the
level of the exchange rate. In particular,since the seminal paper by Meese and
Rogoff (1983) it has become something of stylised fact to argue that exchange rate
forecasts,based on macroeconomic fundamentals,are unable to outperform a
simple random walk. In their survey in the Handbook of International Economics,
Frankel and Rose (1995a) argue that ‘the Meese and Rogoff analysis of short horizons
[less than 36 months] has never been convincingly overturned or explained.
It continues to exert a pessimistic effect on the field of empirical exchange rate
modeling in particular and international finance in general’ (page 23,emphasis
added). Rogoff (1999) has argued something very similar to this.
So it would seem that the level,or mean,of the nominal exchange rate is disconnected
from macroeconomic fundamentals. However,one of the key arguments
of this book is our belief that the variability of and the level of the exchange rate
is explicable in terms of macro-fundamentals and the disconnect story has been
somewhat overplayed.