Working Paper: NBER ID: w23267
Authors: Yinwong Cheung; Menzie D. Chinn; Antonio Garcia Pascual; Yi Zhang
Abstract: Previous assessments of nominal exchange rate determination, following Meese and Rogoff (1983) have focused upon a narrow set of models. Cheung et al. (2005) augmented the usual suspects with productivity based models, and "behavioral equilibrium exchange rate" models, and assessed performance at horizons of up to 5 years. In this paper, we further expand the set of models to include Taylor rule fundamentals, yield curve factors, and incorporate shadow rates and risk and liquidity factors. The performance of these models is compared against the random walk benchmark. The models are estimated in error correction and first-difference specifications. We examine model performance at various forecast horizons (1 quarter, 4 quarters, 20 quarters) using differing metrics (mean squared error, direction of change), as well as the “consistency” test of Cheung and Chinn (1998). No model consistently outperforms a random walk, by a mean squared error measure, although purchasing power parity does fairly well. Moreover, along a direction-of-change dimension, certain structural models do outperform a random walk with statistical significance. While one finds that these forecasts are cointegrated with the actual values of exchange rates, in most cases, the elasticity of the forecasts with respect to the actual values is different from unity. Overall, model/specification/currency combinations that work well in one period will not necessarily work well in another period
Keywords: exchange rate models; predictability; purchasing power parity; interest rate parity
JEL Codes: F31; F47
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| purchasing power parity (F31) | performance of exchange rate models (F37) |
| structural models (E10) | direction of change in exchange rates (F31) |
| forecasts (G17) | actual exchange rates (F31) |
| exchange rate models (F31) | predictability of exchange rates (F31) |
| model specification (C52) | performance of exchange rate models (F37) |