The dynamic relationship between exchange rates and macroeconomic fundamentals: Evidence from Pacific Rim countries

• We explore the linkages between exchange rates and macroeconomic fundamentals.
• The cointegration tests fail to find the LR equilibrium for Pacific Rim countries.
• VECM with breaks reveals exchange rates bear the adjustment to LR equilibrium.
• There is a uni-directional causality in the Canada, Japan and Thailand country-pairs.
• This study also determines the time-varying causality during several sub-periods.

This study explores the linkages between exchange rates and macroeconomic fundamentals to determine the long-run relationship, the short-run dynamic correction as well as the direction of causality for several Pacific Rim countries. The conventional cointegration tests fail to find the long-run equilibrium for any country-pairs except Taiwan, but cointegration tests with structural breaks demonstrate the long-run connections between exchange rates and fundamentals for some country-pairs. Evidence from the VECM with structural breaks reveals that exchange rates bear the burden of adjustment toward the long-run equilibrium in three countries during the floating exchange rate regime. The direction of causality between exchange rates and fundamentals appears to vary over time in the S. Korea–U.S. pair. However, there is a uni-directional causality in the Canada–U.S., Japan–U.S., and Thailand–U.S. country-pairs. That is, the Canadian dollar/dollar, yen/dollar, and baht/dollar exchange rates contain information about future changes in macroeconomic fundamentals which correspond to the implications of the asset-pricing model of exchange rates. Finally, this study determines the time-varying causality between both variables during several sub-periods using a bootstrap rolling window approach for the four country-pairs.