Exchange rates and fundamentals: a non-linear relationship?

We test whether the relationship between changes in the nominal exchange rate and changes in its underlying fundamentals has non-linear features. In order to do so, we extend the Markov-switching model as proposed by McConnell and Perez Quiros (2000) and Dewachter (2001) and test it using a sample of low- and high-inflation countries. The empirical analysis shows that for the high-inflation countries the relationship between news in the fundamentals and the exchange rate changes is stable and significant. This is not the case, however, for the low-inflation countries, where frequent regime switches occur. We develop a non-linear model based on the existence of transactions costs that could explain our empirical findings. We find that this simple non-linear model is capable of replicating the empirical evidence uncovered in this paper. Copyright © 2007 John Wiley & Sons, Ltd.