The (UN-) stable relationship between the exchange rate and its fundamentals

This study investigates the relationship between the euro--dollar exchange rate and its underlying fundamentals by adopting nonlinear time series modelling. We found that this relationship is episodically unstable. We also found that an equilibrium-distorting shock is likely to have a greater effect on the exchange rate during periods when the deviation between exchange rate and fundamentals is large; as a consequence, when the exchange rate is close to its equilibrium value it tends to be less sensitive to any shocks in the fundamentals.