Testing for nonlinear Granger causality from fundamentals to exchange rates in the ERM

This paper presents evidence that two ERM exchange rates are Granger caused in a nonlinear fashion by relative money supply. This finding can be interpreted as evidence that the underlying relationship between money and exchange rates is nonlinear in a target-zone arrangement, which is consistent with the target-zone literature introduced by Krugman, 1991. Target zones and exchange rate dynamics, Q. J. Econ. 106 (3), 669-682. Moreover, we find weak or no evidence that relative output nonlinearly Granger causes the exchange rate. Thus, relative money is more important than relative output in explaining the nonlinearity in the exchange rate-fundamentals relationship. © 2000 Elsevier Science B.V. All rights reserved.