Estimating exchange rate responsiveness to shocks

• Date: 01 December 2008
• DOI: http://doi.org/10.1016/j.rfe.2008.01.001
• Author: Paresh Kumar Narayan
• Published date: 01 December 2008

Estimating exchange rate responsiveness to shocks

Paresh Kumar Narayan⁎

School of Accounting, Economics and Finance, Faculty of Business and Law, Deakin University, Melbourne, Australia

Received 31 January 2007; received in revised form 15 November 2007; accepted 7 January 2008

Available online 8 April 2008

Abstract

The goal of this paper is to examine the importance of permanent and transitory shocks using a more efficient

trend-cycle decomposition of the real exchange rate series. Our main contribution is that in measuring the impact

of shocks, we not only impose common trend restrictions but also common cycle restrictions. We later confirm,

through a post sample forecasting exercise, the efficiency gains from imposing common cycle restrictions. Our

results indicate that permanent shocks are responsible for the bulk of the real exchange rate variations for Japan,

Italy, Germany, France, and the UK vis-à-vis the US dollar over short horizons. For Canada, however, transitory

shocks are dominant over the short horizon. In sum, while for Japan, France, and Italy, around 15% of the variation

in real exchange rate is due to transitory shocks, for Canada, Germany and the UK, over 25% of the variations over

the short horizon are due to transitory shocks. Thus, we claim that the role of transitory shocks should not be

ignored.

© 2008 Elsevier Inc. All rights reserved.

JEL classification: C22; F31

Keywords: Real exchange rates; Trend-cycle decomposition; Permanent and transitory shocks

1. Introduction

The volatility of exchange rates, particularly in the post-Bretton Woods period, has been the central

reason for a growing amount of research on the determinants of exchange rate movements. Essentially, the

Review of Financial Economics 17 (2008) 338–351

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E-mail address: Paresh.Narayan@Deakin.edu.au.

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doi:10.1016/j.rfe.2008.01.001