Real Exchange Rates and Fundamentals in a new Markov-STAR Model*

Abstract

We propose a new nonlinear Markov-STAR model to capture both the Markov switching and smooth transition dynamics for real exchange rates. We derive stationarity conditions for the model and apply it to the real exchange rates of 17 countries. We relate switching equilibrium rates and volatilities to a set of relevant macroeconomic variables and find, consistent with economic intuitions, that an economy deteriorating relative to the US economy tends to see a significantly increased likelihood of real exchange rate depreciation. Moreover, we document significant connections between rising economic uncertainties and real exchange rate changes as well as exchange rate volatility.