Abstract
A theory-consistent CVAR scenario describes a set of testable regularieties one should expect to see in the data if the basic assumptions of the theoretical model are empirically valid. Using this method, the paper demonstrates that all basic assumptions about the shock structure and steady-state behavior of an an imperfect knowledge based model for exchange rate determination can be formulated as testable hypotheses on common stochastic trends and cointegration. This model obtaines remarkable support for almost every testable hypothesis and is able to adequately account for the long persistent swings in the real exchange rate.
Highlights
International macroeconomics is known for its many pricing puzzles, including the purchasing power parity (PPP) puzzle, the exchange rate disconnect puzzle, and the forward rate puzzle
The basic problem stems from an inability of standard models based on the rational expectations hypothesis (REH) to account for highly persistent deviations from PPP and uncovered interest parity (UIP)
The lower panel shows that the persistent long swings in the real exchange rate seem to almost coincide with similar long swings in the real interest rate differential
Summary
International macroeconomics is known for its many pricing puzzles, including the purchasing power parity (PPP) puzzle, the exchange rate disconnect puzzle, and the forward rate puzzle. The basic assumptions underlying the theoretical model into testable hypotheses on the pulling pushing lower panel shows that the persistent long swings in the real exchangeand rate forces of a CVAR model. One may say that such a scenario describes a specified set of testable empirical (deviation from the PPP) seem to almost coincide with similar long swings regularities one should expect to see in the data if the basic assumptions of the theoretical model were empirically valid. The CVAR model is applied to German-US exchange rate data over the post-Bretton Woods, pre-EMU period which is characterized by pronounced persistence from long-run equilibrium states.
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