The Contribution of Observed and Unobserved Fundamentals to Exchange Rate Movements in Iran

Using a State-space model, this paper investigates the contribution of both observed and unobserved fundamentals to nominal exchange rate movement in Iran for the period 1991:2-2011:4. To this end, we follow Engel and West (2005) and Balke et al. (2013) and use an asset-pricing approach to develop a rational expectations present value exchange rate model. In order to examine the role of fundamental factors in exchange rate determination, we estimate the variance contribution of each factor to variance decomposition of the deviation of exchange rate from its long run equilibrium. The random walk Metropolis-Hastings algorithm, Kalman filter and Carter and Kohn algorithm are used to decompose the variance contributions. The results show that the observable fundamentals and the unobserved monetary demand shocks explain about 58.9 and 38.7 percentages of exchange rate fluctuation, respectively. Hence, contrary to previous studies in Iran, which have focused mainly on observable fundamental factors, we find that the unobservable fundamentals also play key role in determining the exchange rate movement in this country. Moreover, we find that the nominal exchange rate does not follow a near random walk behavior. It implies that the foreign exchange rate market in Iran is not efficient. Our findings might have important policy implications for monetary authorities.