Testing for a nonlinear relationship among fundamentals and exchange ratesin the ERM

We employ two nonparametric nonlinear testing methodologies, namely a nonpa rametric nonlinear cointegration approach and a nonlinear Granger causality approach, to test for a nonlinear relationship between macroeconomic funda mentals and exchange rates for two country-pairs, namely the Netherlands-Ge rmany and France-Germany. The results suggest that there is nonlinear coint egration among money, output and exchange rates for Netherlands-Germany, wh ich can be interpreted as evidence of a long-run nonlinear relationship. Fo r France-Germany, we fail to find evidence of nonlinear cointegration, but we find nonlinear Granger causality from French money to the FFr/DM exchang e rate. These findings may be interpreted as evidence of a dynamic nonlinea r relationship and are consistent with the German dominance hypothesis. On the basis of estimated fractional ARIMA models, we rejected the hypothesis that these nonlinearities are due to bubbles. (C) 2000 Elsevier Science Ltd . All rights reserved.