Nonlinearities in exchange rate determination in a small open economy: Some evidence for Canada

We analyze bilateral Canadian-US dollar exchange rate movements within a Markov switching framework with two states, one in which the exchange rate is determined by the monetary model, and the other in which its behavior follows the predictions of a Taylor rule exchange rate model. There are a number of regime switches throughout the estimation period 1991:2–2008:12 which we can each relate to particular changes in Canadian monetary policy. These results imply that an active monetary policy stance may account for nonlinearities in the exchange rate-fundamentals nexus. The strong evidence of nonlinearities also confirms the notion that exchange rate movements cannot be explained exclusively in terms of any one particular exchange rate model.

► We analyze exchange rate movements within a Markov switching framework. ► Switching takes place between the monetary and Taylor rule exchange rate models. ► We can relate the regime switches to particular changes in Canadian monetary policy. ► Monetary policy may account for nonlinearities in exchange rate behavior.