Do macroeconomic variables drive exchange rates independently?

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.