The dynamic relationship between exchange rates and macroeconomic fundamentals: Evidence from Pacific Rim countries

This study explores the linkages between exchange rates and macroeconomic fundamentals to determine the long-run relationship, the short-run dynamic correction as well as the direction of causality for several Pacific Rim countries. The conventional cointegration tests fail to find the long-run equilibrium for any country-pairs except Taiwan, but cointegration tests with structural breaks demonstrate the long-run connections between exchange rates and fundamentals for some country-pairs. Evidence from the VECM with structural breaks reveals that exchange rates bear the burden of adjustment toward the long-run equilibrium in three countries during the floating exchange rate regime. The direction of causality between exchange rates and fundamentals appears to vary over time in the S. Korea-U.S. pair. However, there is a uni-directional causality in the Canada-U.S., Japan-U.S., and Thailand U.S. country-pairs. That is, the Canadian dollar/dollar, yen/dollar, and baht/dollar exchange rates contain information about future changes in macroeconomic fundamentals which correspond to the implications of the asset-pricing model of exchange rates. Finally, this study determines the time-varying causality between both variables during several sub-periods using a boot-strap rolling window approach for the four country-pairs. (C) 2014 Elsevier B.V. All rights reserved.