Non‐linearities,Business Cycles and Exchange Rates

This paper conjoins the disparate empirical literatures on exchange rate models and monetary policy models, with special reference to the importance of output, inflation gaps and exchange rate targets. It focuses in on the dollar/euro exchange rate, and the differential results arising from using alternative measures of the output gap for the US and for the Euro area. A comparison of ‘in‐sample’ prediction against alternative models of exchange rates is also conducted. In addition to predictive power, I also assess the various models' plausibility as economic explanations for exchange rate movements, based on the conformity of coefficient estimates with priors. Taylor rule fundamentals appear to do as well, or better, than other models at the 1‐year horizon.