The dollar-euro exchange rate and macroeconomic fundamentals: a time-varying coefficient approach

This paper investigates the temporal stability of the relationship between the Deutschmark/US dollar exchange rate and macroeconomic fundamentals. We use monthly data from 1975:01 to 2007:12. Applying a novel time-varying coefficient estimation approach, we come up with some interesting properties of our empirical model. Firstly, there is no stable long-run equilibrium relationship among fundamentals and exchange rates, since the breakdown of Bretton Woods. Secondly, there are no recurring regimes, i.e. across different regimes, either the coefficient values for the same fundamentals differ or the significance differs. Thirdly, there is no regime into which no fundamentals enter. Fourthly, the deviations resulting from the stepwise cointegrating relationship act as a significant error-correction mechanism. In other words, we are able to show that fundamentals play an important role in determining the exchange rate, but their impact differs significantly across different subperiods.