Working Paper: NBER ID: w13318
Authors: Charles Engel; Nelson C. Mark; Kenneth D. West
Abstract: Standard models of exchange rates, based on macroeconomic variables such as prices, interest rates, output, etc., are thought by many researchers to have failed empirically. We present evidence to the contrary. First, we emphasize the point that "beating a random walk" in forecasting is too strong a criterion for accepting an exchange rate model. Typically models should have low forecasting power of this type. We then propose a number of alternative ways to evaluate models. We examine in-sample fit, but emphasize the importance of the monetary policy rule, and its effects on expectations, in determining exchange rates. Next we present evidence that exchange rates incorporate news about future macroeconomic fundamentals, as the models imply. We demonstrate that the models might well be able to account for observed exchange-rate volatility. We discuss studies that examine the response of exchange rates to announcements of economic data. Then we present estimates of exchange-rate models in which expected present values of fundamentals are calculated from survey forecasts. Finally, we show that out-of-sample forecasting power of models can be increased by focusing on panel estimation and long-horizon forecasts.
Keywords: No keywords provided
JEL Codes: F31; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| exchange rates (F31) | expectations (D84) |
| expectations (D84) | exchange rates (F31) |
| current economic fundamentals (E66) | exchange rates (F31) |
| news about future macroeconomic fundamentals (E66) | exchange rates (F31) |
| panel estimation (C23) | predictive power of models (C52) |
| long-horizon forecasts (G17) | predictive power of models (C52) |