Using a Theory-Consistent CVAR Scenario to Test an Exchange Rate Model Based on Imperfect Knowledge

Abstract

A theory-consistent CVAR scenario describes a set of testable regularities 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 obtained a remarkable support for almost every testable hypothesis and was able to adequately account for the long persistent swings in the real exchange rate.