Do Fundamentals Matter for the D-Mark/Euro-Dollar? A Regime Switching Approach

In this paper we demonstrate that there is evidence of an unstable and nonlinear re-lationship between fundamentals and exchange rates. Modeling this time-varying nature of the importance of fundamentals in a Markov switching framework substan-tially improves the fit of the real interest rate differential model and leads to parame-ter estimates, which in one regime are in line with theoretical expectations and allow us to draw reasonable conclusions on the influence of fundamentals on exchange rate dynamics. Factors which prove to be closely related to regime switches are short term interest rate, inflation differentials and differences in economic growth. There-fore fundamentals do not only matter for the exchange rate within each regime, but are also related to the switches between the regimes.