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Exchange rate predictability and a monetary model with time-varying cointegration coefficients

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  • Park, Cheolbeom
  • Park, Sookyung

Abstract

Many studies have pointed out that the underlying relations and functions for the monetary model (e.g. the PPP relation, the money-demand function, monetary policy rule, etc.) have undergone parameter instabilities and that the relation between exchange rates and macro fundamentals is unstable due to the shift in the economic models in foreign exchange traders' views or the scapegoat effect in Bacchetta and van Wincoop (2009). Facing this, we consider a monetary model with time-varying cointegration coefficients in order to understand exchange rate movements. We provide statistical evidence against the standard monetary model with constant cointegration coefficients but find favorable evidence for the time-varying cointegration relationship between exchange rates and monetary fundamentals. Furthermore, we demonstrate that deviations between the exchange rate and fundamentals from the time-varying cointegration relation have strong predictive power for future changes in exchange rates through in-sample analysis, out-of-sample analysis, and directional accuracy tests.

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Bibliographic Info

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

Volume (Year): 37 (2013)
Issue (Month): C ()
Pages: 394-410

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Handle: RePEc:eee:jimfin:v:37:y:2013:i:c:p:394-410

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

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Keywords: Exchange rate; Monetary model; Predictability; Time-varying cointegration;

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References

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Cited by:
  1. Joseph Byrne & Dimitris Korobilis & Pinho Ribeiro, 2014. "Exchange Rate Predictability in a Changing World," Papers 1403.0627, arXiv.org.

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