Testing for bubbles in exchange markets: a case of sparkling rates?

This paper investigates the possibility that the observed deviations of major bilateral exchange rates from values implied by market fundamentals are a consequence of rational asset market bubbles. When a new econometric methodology for detecting asset market bubbles is used, the joint hypothesis of no bubbles and stable autoregressive processes for relative money supplies and real incomes is rejected for the dollar/deutsche mark and dollar/pound ratesusing monthly data over the period 1973-82. Additional tests for coefficient stability and for lack of cointegration between exchange rates and market fundamentals suggest that the bubble findings must be interpreted with care.