Working Paper: CEPR ID: DP6638
Authors: Lucio Sarno; Giorgio Valente
Abstract: Using novel real-time data on a broad set of economic fundamentals for five major US dollar exchange rates over the recent float, we employ a predictive procedure that allows the relationship between exchange rates and fundamentals to evolve over time in a very general fashion. Our key findings are that: (i) the well-documented weak out-of-sample predictive ability of exchange rate models may be caused by poor performance of model-selection criteria, rather than lack of information content in the fundamentals; (ii) the difficulty of selecting the best predictive model is largely due to frequent shifts in the set of fundamentals driving exchange rates, which can be interpreted as reflecting swings in market expectations over time. However, the strength of the link between exchange rates and fundamentals is different across currencies.
Keywords: Economic fundamentals; Exchange rates; Forecasting
JEL Codes: F31; G10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Model selection criteria (C52) | Predictive ability of exchange rate models (F37) |
| Shifts in fundamentals (F31) | Predictive ability of exchange rate models (F37) |
| Economic fundamentals (P19) | Future exchange rate movements (F31) |
| Model selection criteria (C52) | Exchange rate disconnect phenomenon (F31) |
| Poor model selection criteria (C52) | Weak relationship between exchange rates and fundamentals (F31) |