Working Paper: CEPR ID: DP3024
Authors: Lutz Kilian; Mark P. Taylor
Abstract: We propose an exchange rate model that can explain both the observed volatility and the persistence of real and nominal exchange rate movements and thus in some measure resolves Rogoff?s (1996) purchasing power parity puzzle. Our analysis reconciles the well-known difficulties in beating the random walk forecast model with the statistical evidence of nonlinear mean reversion in deviations from fundamentals. Our analysis also provides a compelling rationale for the long-horizon predictability of exchange rates. We find strong empirical support for long-horizon predictability, and we explain why it is difficult to exploit this predictability in real-time forecasts. Our results not only lend support to economists? beliefs that the exchange rate is inherently predictable, but they also help us to understand the reluctance of applied forecasters to abandon chartist methods in favor of models based on economic fundamentals.
Keywords: economic models of exchange rate determination; long-horizon regression tests; purchasing power parity; random walk; real exchange rate
JEL Codes: C53; F31; F47
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| deviations from economic fundamentals (E32) | predictability of exchange rates (F31) |
| large deviations from fundamentals (E32) | predictability of exchange rates (F31) |
| forecast horizon lengthening (C53) | predictability of exchange rates (F31) |
| exchange rate moving away from equilibrium (F31) | strength of link between exchange rates and fundamentals (F31) |