Authors: Young Min Kim(Korea University) Seojin Lee(Shanghai Lixin University of Accounting and Finance)

Recent literature emphasizes the role of unobservable fundamentals in exchange rate movements. Within the state-space model and the Bayesian approach, proposed by Balke et al. (2013), we find that unobservable fundamentals, such as the risk premium, the deviation from the purchasing power parity, and money demand shifters explain most of the Korea exchange rate fluctuations. In contrast, observed monetary fundamentals have much less effect. This result implies that Korean exchange rate movements are closely related to market expectations or sudden capital flows, rather than economic fundamentals.