On the indirect causality relation from exchange rates to fundamentals

In this study, we examine whether the monetary-transmission mechanism of exchange rate changes also explains the finding of the causality relation from exchange rates to fundamentals, which is taken as a validation for the present value model for exchange rates in a prominent work. To take account of the indirect causality relation between variables implied by the monetary-transmission mechanism, we apply the method proposed by Dufour and Taamouti (2010) to estimate the causality and perform the test. We observe that the causality relation from exchanger rates to UIP and PPP fundamentals could be stronger in the middle horizon than the short and long horizon, which implies the exchange rate change has inertial effect on the fundamentals. However, the effect is not statistically significant, which implies that the role of the exchange rate may not be so important as to influence the monetary policy rule.