A dynamic econometric analysis of the dollar-pound exchange rate in an era of structural breaks and policy regime shifts

Abstract

We employ a newly-developed partial cointegration system allowing for level shifts to examine whether economic fundamentals form the long-run determinants of the dollar-pound exchange rate over a recent period characterised by structural breaks and policy regime shifts. The paper models both long-run and short-run dynamic features of the exchange rate using a set of economic variables that explicitly reflect quantitative monetary policy and the influence of a forward exchange market. Out-of-sample forecasts comparing the model with economic fundamentals to benchmarks including the random walk indicate that fundamentals can help at short horizons but less so at longer horizons.