Abstract:
This paper provides a long-term perspective on the causal linkages between currency dynamics and macroeconomic conditions. We utilise a long-span data set for the United Kingdom that extends back to 1856, and a time-varying causality testing methodology that accounts for nonlinearity and structural breaks. Using unemployment fluctuations as a proxy for macroeconomic conditions and wavelet decompositions to obtain the fundamental factor that drives excess returns for the British pound, time-varying causality tests based on alternative model specifications yield significant evidence of causal linkages and information spillovers across labour and currency markets over the majority of the sample. Causal effects seem to strengthen during the Great Depression and later following the collapse of the Bretton Woods system, highlighting the role of economic crises in the predictive linkages between the two markets. While the predictive role of currency market dynamics over unemployment fluctuations reflects the effect of exchange rate volatility on corporate investment decisions, which in turn drives subsequent labour market dynamics, we argue that causality in the direction of exchange rates from unemployment possibly reflects signals regarding monetary policy actions, which in turn spill over to financial markets. Overall, the findings indicate significant information spillovers across labour and currency markets in both directions with significant policy making implications.
