The forward‐looking ability of the real exchange rate and its misalignment to forecast the economic performance and the stock market return

Abstract

AbstractThis paper aims to examine whether exchange rates can predict future changes in the stock market return and in the economic performance of a country. On the basis of a revision that incorporates relative stock price and rational expectation in Dornbusch's dynamic Mundell–Fleming model, I present a model that can be used for analysing the forward‐looking ability of the real exchange rate. The model builds on the works of Campbell and Shiller (Journal of Political Economy, 95, 1987 and 1062), MacDonald and Taylor (IMF Staff Papers, 40, 1993 and 89) and Engel (American Economic Review, 106, 2016 and 436) which can also be converted into a forward‐looking version of real exchange rate misalignment model to investigate whether the deviation of the real exchange rate from its fundamental value would contain an economically significant predictable component on forecasting the future stock price movement and the real output.