How to beat the random walk. An empirical model of real exchange rates

An econometric model is developed for all possible bilateral real exchange rates between the United States, the United Kingdom, Germany and Japan for the period February 1977 to June 1987. We extend the standard Dornbusch-Frankel type of models using an error correction approach with an observable macro-economic determinant of the long-run real exchange rate. For the econometric analysis we develop an efficient estimator by pooling the data for all currencies. Contrary to previous empirical tests on the long-run behaviour of real exchange rates, we find a notable and significant mean reversion component. © 1990.