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A new approach to forecasting exchange rates

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  • Clements, Kenneth W.
  • Lan, Yihui

Abstract

Building on purchasing power parity theory, this paper proposes a new approach to forecasting exchange rates using the Big Mac data from The Economist magazine. Our approach is attractive in three aspects. Firstly, it uses easily-available Big Mac prices as input. These prices avoid several potential problems associated with broad price indexes, such as the consumer price index used in conventional PPP studies. Secondly, this approach provides real-time exchange-rate forecasts at any forecast horizon. These high-frequency forecasts could be appealing to those who want up-to-date exchange-rate forecasts. Finally, as our forecasts are obtained through a simulation procedure, estimation uncertainty is made explicit in our framework that provides the entire distribution of exchange rates, not just a single point estimate. Using exchange rates of six major currencies to illustrate the approach, we compare the Big Mac forecasts with those derived from a random walk and the CPI and find some support for our approach, especially at longer term horizons.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of International Money and Finance.

Volume (Year): 29 (2010)
Issue (Month): 7 (November)
Pages: 1424-1437

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Handle: RePEc:eee:jimfin:v:29:y:2010:i:7:p:1424-1437

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Web page: http://www.elsevier.com/locate/inca/30443

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Keywords: Exchange-rate forecasting Big Mac prices Purchasing power parity Simulation;

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  1. Kenneth W Clements & Yihui Lan & Shi Pei Seah, 2010. "The Big Mac Index Two Decades On An Evaluation Of Burgernomics," Economics Discussion / Working Papers 10-14, The University of Western Australia, Department of Economics.
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Cited by:
  1. Kenneth W Clements & Yihui Lan & John Roberts, 2007. "Exchange-Rate Economics for the Resources Sector," Economics Discussion / Working Papers 07-13, The University of Western Australia, Department of Economics.

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