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Do macroeconomic variables drive exchange rates independently?

Author

Listed:
  • Biswas, Rita
  • Li, Xiao
  • Piccotti, Louis R.
Abstract
The classical practice in exchange rate model estimation is to use bilateral differentials of macroeconomic variables. Empirically, capital may not place equal importance on the economic variables among all countries. Therefore, allowing each country's variable to enter the model independently may reduce estimation error. Based on simulations, we find that higher correlations between the two countries’ variables tend to inflate prediction errors when the estimation uses bilateral differentials. Applying the Sticky Price Monetary Model (SPMM) to a wide range of countries we find supportive evidence for separating the variables, a finding especially relevant for smaller economies.

Suggested Citation

  • Biswas, Rita & Li, Xiao & Piccotti, Louis R., 2023. "Do macroeconomic variables drive exchange rates independently?," Finance Research Letters, Elsevier, vol. 52(C).
    • Handle: RePEc:eee:finlet:v:52:y:2023:i:c:s1544612322007000
    DOI: 10.1016/j.frl.2022.103524
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Exchange rate determination; Macro fundamental models; Machine learning regression; Elastic net;
    All these keywords.

    JEL classification:

    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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