Testing the Canonical Model of Exchange Rates with Unobservable Fundamentals

Javier Gardeazabal, Universidad del País Vasco
Marta Regúlez, Universidad del País Vasco
Jesús Vázquez, Universidad del País Vasco

Abstract

In this paper we test the asset market approach or canonical model of exchange rates. We treat exchange rate fundamentals as unobservable. The empirical results do not reject the canonical model, and therefore the embedded rational expectations assumption, in sharp contrast with previous empirical evidence. We also find evidence of feedback from the exchange rate to fundamentals, which is normally omitted in the theoretical literature.