Macroeconomic fundamentals and the exchange rate dynamics: A no-arbitrage macro-finance approach

In this paper, we propose an arbitrage-free international macro-finance model that links the exchange rate dynamics to macro-economic fundamentals. jointly using data on exchange rates, yields of zero-coupon bonds, and macroeconomic variables of the US and the Euro area, we find a close link between macroeconomic fundamentals and the exchange rate dynamics. The model-implied monthly exchange rate changes can explain about 57% variation of the observed data. The macroeconomic innovations can help capture large variation of exchange rate changes. Robustness checks show that the results also hold for other major exchange rates. (C) 2013 Elsevier Ltd. All rights reserved.