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Can Parameter Instability Explain the Meese-Rogoff Puzzle?

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  • Bacchetta, Philippe
  • Beutler, Toni
  • van Wincoop, Eric

Abstract

The empirical literature on nominal exchange rates shows that the current exchange rate is often a better predictor of future exchange rates than a linear combination of macroeconomic fundamentals. This result is behind the famous Meese-Rogoff puzzle. In this paper we evaluate whether parameter instability can account for this puzzle. We consider a theoretical reduced-form relationship between the exchange rate and fundamentals in which parameters are either constant or time varying. We calibrate the model to data for exchange rates and fundamentals and conduct the exact same Meese-Rogoff exercise with data generated by the model. Our main finding is that the impact of time-varying parameters on the prediction performance is either very small or goes in the wrong direction. To help interpret the findings, we derive theoretical results on the impact of time-varying parameters on the out-of-sample forecasting performance of the model. We conclude that it is not time-varying parameters, but rather small sample estimation bias, that explains the Meese-Rogoff puzzle.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7383.

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Date of creation: Jul 2009
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Handle: RePEc:cpr:ceprdp:7383

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Keywords: Exchange rate forecasting; exchange rate models;

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References

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  1. Eric van Wincoop & Philippe Bacchetta, 2004. "Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?," Econometric Society 2004 North American Winter Meetings 628, Econometric Society.
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Citations

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Cited by:
  1. Rossi, Barbara & Sekhposyan, Tatevik, 2011. "Understanding models' forecasting performance," Journal of Econometrics, Elsevier, vol. 164(1), pages 158-172, September.
  2. Philippe Bacchetta & Eric van Wincoop, 2009. "On the Unstable Relationship between Exchange Rates and Macroeconomic Fundamentals," Working Papers 272009, Hong Kong Institute for Monetary Research.
  3. Marcel Fratzscher & Lucio Sarno & Gabriele Zinna, 2013. "The Scapegoat Theory of Exchange Rates: The First Tests," Discussion Papers of DIW Berlin 1290, DIW Berlin, German Institute for Economic Research.
  4. Cheolbeom Park & Sookyung Park, 2013. "Exchange Rate Predictability and a Monetary Model with Time-varying Cointegration Coefficients," Discussion Paper Series 1302, Institute of Economic Research, Korea University.
  5. Barbara Rossi, 2013. "Exchange Rate Predictability," Working Papers 690, Barcelona Graduate School of Economics.
  6. Philippe Bacchetta & Eric van Wincoop, 2011. "Modeling Exchange Rates with Incomplete Information," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 11.03, Université de Lausanne, Faculté des HEC, DEEP.
  7. Travis J. Berge, 2011. "Forecasting disconnected exchange rates," Research Working Paper RWP 11-12, Federal Reserve Bank of Kansas City.
  8. Barbara Rossi, 2011. "Advances in Forecasting Under Instability," Working Papers 11-20, Duke University, Department of Economics.
  9. Toni Beutler, 2012. "Forecasting Exchange Rates with Commodity Convenience Yields," Working Papers 12.03, Swiss National Bank, Study Center Gerzensee.

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