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Real exchange rate forecasting: a calibrated half-life PPP model can beat the random walk

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Abstract

This paper brings two new insights into the Purchasing Power Parity (PPP) debate. First, even if PPP is thought to hold only in the long run, we show that a half-life PPP model outperforms the random walk in real exchange rate forecasting, also at short-term horizons. Second, we show that this result holds as long as the speed of adjustment to the sample mean is imposed and not estimated. The reason is that the estimation error of the pace of convergence distorts the results in favor of the random walk model, even if the PPP holds in the long-run.

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File URL: http://www.nbp.pl/publikacje/materialy_i_studia/123_en.pdf
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Bibliographic Info

Paper provided by National Bank of Poland, Economic Institute in its series National Bank of Poland Working Papers with number 123.

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Length: 21
Date of creation: 2012
Date of revision:
Handle: RePEc:nbp:nbpmis:123

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Keywords: Exchange rate forecasting; purchasing power parity; half-life;

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  1. Francis X. Diebold & Robert S. Mariano, 1994. "Comparing Predictive Accuracy," NBER Technical Working Papers 0169, National Bureau of Economic Research, Inc.
  2. Norman, Stephen, 2010. "How well does nonlinear mean reversion solve the PPP puzzle?," Journal of International Money and Finance, Elsevier, vol. 29(5), pages 919-937, September.
  3. Mark, Nelson C. & Choi, Doo-Yull, 1997. "Real exchange-rate prediction over long horizons," Journal of International Economics, Elsevier, vol. 43(1-2), pages 29-60, August.
  4. Alan M. Taylor & Mark P. Taylor, 2004. "The Purchasing Power Parity Debate," Journal of Economic Perspectives, American Economic Association, vol. 18(4), pages 135-158, Fall.
  5. Barbara Rossi, 2005. "Are Exchange Rates Really Random Walks? Some Evidence Robust to Parameter Instability," Data 0503001, EconWPA.
  6. Lutz Kilian & Tao Zha, 2002. "Quantifying the uncertainty about the half-life of deviations from PPP," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 17(2), pages 107-125.
  7. López-Suárez, Carlos Felipe & Rodríguez-López, José Antonio, 2011. "Nonlinear exchange rate predictability," Journal of International Money and Finance, Elsevier, vol. 30(5), pages 877-895, September.
  8. Jon Faust & John H. Rogers & Jonathan H. Wright, 2001. "Exchange rate forecasting: the errors we've really made," International Finance Discussion Papers 714, Board of Governors of the Federal Reserve System (U.S.).
  9. Christian J. Murray & David H. Papell, 2000. "The Purchasing Power Parity Persistence Paradigm," Econometric Society World Congress 2000 Contributed Papers 0017, Econometric Society.
  10. Chinn, Menzie D. & Meese, Richard A., 1995. "Banking on currency forecasts: How predictable is change in money?," Journal of International Economics, Elsevier, vol. 38(1-2), pages 161-178, February.
  11. Mark, Nelson C. & Sul, Donggyu, 2001. "Nominal exchange rates and monetary fundamentals: Evidence from a small post-Bretton woods panel," Journal of International Economics, Elsevier, vol. 53(1), pages 29-52, February.
  12. Efthymios G. Pavlidis & Ivan Paya & David A. Peel, 2012. "Forecast Evaluation of Nonlinear Models: The Case of Long‐Span Real Exchange Rates," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 31(7), pages 580-595, November.
  13. Mark, Nelson C, 1995. "Exchange Rates and Fundamentals: Evidence on Long-Horizon Predictability," American Economic Review, American Economic Association, vol. 85(1), pages 201-18, March.
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Cited by:
  1. Michele Ca'Zorzi & Alexander Chudik, 2013. "Spatial considerations on the PPP debate," Globalization and Monetary Policy Institute Working Paper 138, Federal Reserve Bank of Dallas.

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