Can long-horizon forecasts beat the random walk under the Engel-West explanation?
AbstractEngel and West (EW, 2005) argue that as the discount factor gets closer to one, present-value asset pricing models place greater weight on future fundamentals. Consequently, current fundamentals have very weak forecasting power and exchange rates appear to follow approximately a random walk. We connect the Engel-West explanation to the studies of exchange rates with long-horizon regressions. We find that under EW's assumption that fundamentals are I(1) and observable to the econometrician, long-horizon regressions generally do not have significant forecasting power. However, when EW's assumptions are violated in a particular way, our analytical results show that there can be substantial power improvements for long-horizon regressions, even if the power of the corresponding short-horizon regression is low. We simulate population R squared for long-horizon regressions in the latter setting, using Monetary and Taylor Rule models of exchange rates calibrated to the data. Simulations show that long-horizon regression can have substantial forecasting power for exchange rates.
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Bibliographic InfoPaper provided by Federal Reserve Bank of Dallas in its series Globalization and Monetary Policy Institute Working Paper with number 36.
Date of creation: 2009
Date of revision:
This paper has been announced in the following NEP Reports:
- NEP-ALL-2009-10-03 (All new papers)
- NEP-CBA-2009-10-03 (Central Banking)
- NEP-FOR-2009-10-03 (Forecasting)
- NEP-IFN-2009-10-03 (International Finance)
- NEP-OPM-2009-10-03 (Open Economy Macroeconomics)
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- Jian Wang & Jason J. Wu, 2009.
"The Taylor rule and forecast intervals for exchange rates,"
International Finance Discussion Papers
963, Board of Governors of the Federal Reserve System (U.S.).
- Jian Wang & Jason J. Wu, 2012. "The Taylor Rule and Forecast Intervals for Exchange Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 44(1), pages 103-144, 02.
- Jian Wang & Jason J. Wu, 2008. "The Taylor rule and forecast intervals for exchange rates," Globalization and Monetary Policy Institute Working Paper 22, Federal Reserve Bank of Dallas.
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