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

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. Key words: Markov regime-switching, testing, forecasting, exchange rates. JEL classi…cation: F31, C52, C53. ¤Correspondence to: Franc Klaassen, Department of Economics, Tilburg University, P.O. Box 90153, 5000 LE Tilburg, the Netherlands; tel: +31-13-4668229; fax: +31-13-4663280; E-mail: [email protected]. I would like to thank Frank de Jong, Harry Huizinga, Bertrand Melenberg and Siem Jan Koopman for their helpful comments.