Nonlinearities in exchange rate determination in a small open economy: Some evidence for Canada

Enhancing the forecasting power of exchange rate models by introducing nonlinearity: Does it work?

“…Markov-switching models are popular because they capture the exchange rate adjustment process through a transition probability that is a function of the lagged deviation of the exchange rate from its equilibrium level (Hamilton, 1989). Kempa and Riedel (2013) estimate a Markov switching model for the bilateral Canadian-U.S. dollar exchange rate and find that an active monetary policy stance may account for nonlinearity in the exchange ratefundamentals nexus and that nonlinearity confirms the notion that exchange rate movements cannot be explained exclusively in terms of any one particular exchange rate model. Kruse et al (2012) criticise the disproportionately large body of literature in which ESTAR models are used whilst neglecting competing nonlinear models, such as the Markov switching AR model.…”