Macroeconomic fundamentals and the exchange rate dynamics: A no-arbitrage macro-finance approach

•An arbitrage-free international macro-finance model is proposed.•A close link between macroeconomic fundamentals and the exchange rate dynamics is found.•57% variation of the observed data can be explained.•The results are robust for other major exchange rates.

In this paper, we propose an arbitrage-free international macro-finance model that links the exchange rate dynamics to macroeconomic fundamentals. Jointly using data on exchange rates, yields of zero-coupon bonds, and macroeconomic variables of the US and the Euro area, we find a close link between macroeconomic fundamentals and the exchange rate dynamics. The model-implied monthly exchange rate changes can explain about 57% variation of the observed data. The macroeconomic innovations can help capture large variation of exchange rate changes. Robustness checks show that the results also hold for other major exchange rates.