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What Do We Know about Recent Exchange Rate Models? In-Sample Fit and Out-of-Sample Performance Evaluated

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  • Cheung, Yin-Wong
  • Chinn, Menzie
  • Garcia Pascual, Antonio

Abstract

Previous assessments of nominal exchange rate determination have focused upon a narrow set of models typically of the 1970’s vintage, including monetary and portfolio balance models. In this paper we re-assess the in-sample fit and out-of-sample prediction of a wider set of models that have been proposed in the last decade, namely interest rate parity, productivity based models, and "behavioral equilibrium exchange rate" models. These models are compared against a benchmark model, the Dornbusch-Frankel sticky price monetary model. First, the parameter estimates of the models are compared against the theoretically predicted values. Second, we conduct an extensive out-of-sample forecasting exercise, using the last eight years of data to determine whether our in-sample conclusions hold up. 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). We find that no model fits the data particularly well, nor does any model consistently out-predict a random walk, even at long horizons. There is little correspondence between how well a model conforms to theoretical priors and how well the model performs in a prediction context. However, we do confirm previous findings that out-performance of a random walk is more likely at long horizons.

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Bibliographic Info

Paper provided by Department of Economics, UC Santa Cruz in its series Santa Cruz Department of Economics, Working Paper Series with number qt0jc800x9.

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Date of creation: 01 Oct 2003
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Handle: RePEc:cdl:ucscec:qt0jc800x9

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Keywords: exchange rates; monetary model; productivity; interest rate parity; behavioral equilibrium exchange rate model; forecasting performance;

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Cited by:
  1. Ho, Catherine S.F. & Ariff, M., 2012. "Time to equilibrium in exchange rates: G-10 and Eastern European economies," Global Finance Journal, Elsevier, vol. 23(2), pages 94-107.
  2. Buncic, Daniel & Melecky, Martin, 2007. "An estimated New Keynesian policy model for Australia," MPRA Paper 4138, University Library of Munich, Germany.
  3. Melecky, M, 2007. "Currency Preferences in a Tri-Polar Model of Foreign Exchange," MPRA Paper 4186, University Library of Munich, Germany.
  4. Bofinger, Peter & Leitner, Johannes & Schmidt, Robert, 2004. "Biases of Professional Exchange Rate Forecasts: Psychological Explanations and an Experimentally-Based Comparison to Novices," CEPR Discussion Papers 4230, C.E.P.R. Discussion Papers.

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