Long Swings in Exchange Rates: Are They Really in the Data?

Abstract

The random walk is often used to model exchange rates. According to the Lucas critique, however, policy shifts may lead to breaks in the trend of exchange rates and hence to long swings. We use a Markov regime-switching model to allow for such swings and we reject the random walk in favor of the regime-switching model. Earlier papers report this result too, but the authors are concerned about the reliability of their Wald based tests in the strongly nonlinear regime-switching model. We show that these tests are indeed not very robust. Hence, we use a likelihood ratio test for which the (non-standard) critical values have been computed recently.Markov regime-switching;testing;forecasting;exchange rates