Are exchange rates ultimately tied down by economic fundamentals? Or are they free to drift at random on a sea of speculation? Writing in the latest issue of the Economic Journal, Professor Ronald Macdonald challenges the conventional wisdom by arguing that traditional economic fundamentals – such as relative money supplies, current account positions and relative interest rates – can be used to produce impressive forecasts of exchange rate movements at horizons as short as two months ahead. He also argues that such fundamentals can be used to obtain measures of an ''equilibrium exchange rate'', an attractive proposition for policy-makers, companies and
foreign exchange traders interested in assessing if a currency is under- or overvalued.
Macdonald notes the conventional view that the best available model of exchange rate movements over a horizon of up to three years is a ''random walk''. Essentially, this means that movements in exchanges rates over this time span are unforecastable. The random walk consensus has very uncomfortable conclusions. Many financial institutions, for example, are interested in hedging exchange rate movements at horizons of much shorter duration than 36 months.
Macdonald''s results offer hope for would-be forecasters, suggesting that currencies can be forecast using standard criteria at horizons as short as two months ahead. These are ''real time'' forecasts in the sense that they could have been used by foreign exchange dealers. The success of these forecasts comes from the use of state-of-the-art econometric methods, which capture both the short-run dynamics and the longer-run mean reversion in exchange rates – the tendency to return to average conditions.
The research also indicates that traditional fundamentals can be used to say something positive about the equilibrium value of a currency. This is useful for policy-makers if the actual values of currencies take long swings away from their underlying fundamentals before reverting to the mean. Knowing the equilibrium value of a currency may also be of value if a country is considering joining a monetary union, such as EMU.
Macdonald demonstrates that the model that economists often turn to first for a fix on the equilibrium value of a currency – namely, purchasing power parity (PPP) – is not particularly useful for this purpose. There are two problems. One is that the empirical form of PPP is often very different to the textbook definition (coefficients on prices are often very far from their prior values). Second, the speed with which exchange rates move towards PPP, the so-called half-life, is regarded as being far too slow to be consistent with a traditional form of PPP. Macdonald shows that that relatively simple measures of equilibrium may be obtained from models that explicitly recognise the real factors driving exchange rates.
''Exchange Rate Behaviour: Are Fundamentals Important?'' by Ronald Macdonald is published in the November 1999 issue of the Economic Journal. Macdonald is Professor of Economics at the University of Strathclyde.