This paper investigates the possibility that the observed deviations of major bilateral exchange rates from values implied by market fundamentals are a consequence of rational asset market bubbles. When a new econometric methodology for detecting asset market bubbles is used, the joint hypothesis of no bubbles and stable autoregressive processes for relative money supplies and real incomes is rejected for the dollar/deutsche mark and dollar/pound ratesusing monthly data over the period 1973-82. Additional tests for coefficient stability and for lack of cointegration between exchange rates and market fundamentals suggest that the bubble findings must be interpreted with care.

ABSTRACT In this paper, we explore the relationship between real exchange rates and real interest rate differentials in the United States, Germany, Japan, and the United Kingdom. Contrary to theories based on the joint hypothesis that domestic prices are sticky and monetary disturbances are predominant, we find little evidence of a stable relationship between real interest rates and real exchange rates. We consider both in‐sample and out‐of‐sample tests. One hypothesis that is consistent with our findings is that real disturbances (such as productivity shocks) may be a major source of exchange rate volatility.

ABSTRACT Tests are conducted for the presence of unit roots in the autoregressive representations of the logarithms of spot and forward exchange rates. The results from these tests provide one explanation for some of the conflicting conclusions which emerge from recent empirical papers on the foreign exchange market.

In this paper, we explore the relationship between real exchange rates and real interest rate differentials in the United States, Germany, Japan, and the United Kingdom. Contrary to theories based on the joint hypothesis that domestic prices are sticky and monetary disturbances are predominant, we find little evidence of a stable relationship between real interest rates and real exchange rates. We consider both in-sample and out-of-sample tests. One hypothesis that is consistent with our findings is that real disturbances (such as productivity shocks) may be a major source of exchange rate volatility.

A wide variety of empirical exchange rate mo.dels have been estimated over the years. But, despite the considerable energies that have been devoted to this work, the economics profession has remarkably little to show for itself. There is little evidence that conclusively links the bilateral exchange rates of typical OECD countries to fundamental macroeconomic determinants of exchange rates, such as money, output, relative prices, or interest differentials. Coefficient estimates are notoriously unstable and frequently mis-signed (compared with theoretical predictions); exchange rate equations do not fit particularly well, and forecast no better than the simplest naive alternatives. Recently, a new class of exchange rate models was introduced by Paul Krugman (1988). These models provide a potential reason for the poor performance of traditional exchange rate models, because they are nonlinear. If the exchange rate actually depends in a nonlinear way on exogenous macroeconomic fundamentals, linear exchange rate models may work poorly, even though the exchange rate is closely linked to fundamentals. In this paper we provide a brief sketch of some of this work, as well as some preliminary evidence on the actual performance of these nonlinear models. In our empirical analysis, we use a nonparametric estimator that can handle a wide variety of nonlinear phenomena. We examine fixed exchange rate regimes, where nonlinearities should be quite easy to detect. However, we do not find strong empirical support for the hypothesis that the incorporation of nonlinear effects significantly improves models of exchange rate determination. In Section I, we briefly review the theoretical literature on nonlinear target zone exchange rate models, linking this work to the tests for intrinsic bubbles (we draw heavily on recent papers by Kenneth Froot and Maurice Obstfeld, 1989a,b). Our methodology and data are discussed in Section II; Section III contains new empirical tests for nonlinearities in exchange rate models.