Macroeconomic fundamentals and the dm/$ exchange rate: Temporal instability and the monetary model

The findings of this study lead to three conclusions. First, the process governing the short-run movement of exchange rates over periods of floating is episodically unstable. Second, the switching nature of the exchange rate process takes a striking form, namely that different sets of macroeconomic fundamentals matter for exchange rates during different time periods. Finally, it is difficult to reconcile these structural change findings with the monetary model with RE. The implausibility of relying on changes in the structure of the model under RE as a way to explain the temporal instability of the monetary model suggests that what is required is an alternative expectational framework that breaks the rigid connection between expectations functions and the one 'true' semi-reduced form. The TCE framework achieves this end by recognizing that agents possess a pluralism of theories with which to look forward and it assumes that their theories provide only qualitative knowledge about how the exchange rate might be related to some set of fundamentals.²⁵ With imperfect knowledge, as formulated by the TCE framework, agents may change the theories (or sets of fundamentals) they use to forecast exchange rate movements from one time period to another. It is this possibility of changing beliefs that allows the monetary model with TCE to be reconciled with the our finding that different sets of macroeconomic fundamentals matter for short-run exchange rate movements during different time periods. The conclusion is that if one is prepared to move away from the RE paradigm and recognize that market agents possess imperfect knowledge, then plausible interpretations of the connection between floating exchange rates and macroeconomic fundamentals might after all become possible.