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Was it Real? The Exchange Rate-Interest Differential Relation, 1973-1984

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  • Richard Meese
  • Kenneth Rogoff

Abstract

The main result of Meese and Rogoff [1983 a,b] is that small structural exchange rate models forecast major dollar exchange rates no better than a naive random walk model. This result obtains even when the model forecasts are based on actual realized values of the explanatory variables. Here we improve our methodology by implementing a new test of out-of-sample fit; the test is valid even for overlapping long-horizon forecasts. We find that the dollar exchange rate models perform somewhat less badly over the recent Reagan regime period than over the episodes studied previously. The methodology is also applied to the mark/yen and mark/pound exchange rates, and to real exchange rates. Finally, we test to see if real exchange rates and real interest differentials can be represented as a cointegrated process. The evidence suggests that there is no single common influence inducing nonstationarity in both real exchange rates and real interest differentials.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1732.

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Date of creation: Feb 1989
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Handle: RePEc:nbr:nberwo:1732

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  1. Richard Meese & Kenneth Rogoff, 1983. "The Out-of-Sample Failure of Empirical Exchange Rate Models: Sampling Error or Misspecification?," NBER Chapters, in: Exchange Rates and International Macroeconomics, pages 67-112 National Bureau of Economic Research, Inc.
  2. Hamilton, James D. & Whiteman, Charles H., 1985. "The observable implications of self-fulfilling expectations," Journal of Monetary Economics, Elsevier, vol. 16(3), pages 353-373, November.
  3. Michael P. Dooley & Jeffrey R. Shafer, 1976. "Analysis of short-run exchange behavior: March, 1993 to September, 1975," International Finance Discussion Papers 76, Board of Governors of the Federal Reserve System (U.S.).
  4. Henriksson, Roy D & Merton, Robert C, 1981. "On Market Timing and Investment Performance. II. Statistical Procedures for Evaluating Forecasting Skills," The Journal of Business, University of Chicago Press, vol. 54(4), pages 513-33, October.
  5. Meese, Richard A, 1986. "Testing for Bubbles in Exchange Markets: A Case of Sparkling Rates?," Journal of Political Economy, University of Chicago Press, vol. 94(2), pages 345-73, April.
  6. Robert E. Cumby & Maurice Obstfeld, 1985. "International Interest-Rate and Price-Level Linkages Under Flexible Exchange Rates: A Review of Recent Evidence," NBER Working Papers 0921, National Bureau of Economic Research, Inc.
  7. Adler, Michael & Lehmann, Bruce, 1983. " Deviations from Purchasing Power Parity in the Long Run," Journal of Finance, American Finance Association, vol. 38(5), pages 1471-87, December.
  8. Meese, Richard A & Singleton, Kenneth J, 1982. " On Unit Roots and the Empirical Modeling of Exchange Rates," Journal of Finance, American Finance Association, vol. 37(4), pages 1029-35, September.
  9. Hooper, Peter & Morton, John, 1982. "Fluctuations in the dollar: A model of nominal and real exchange rate determination," Journal of International Money and Finance, Elsevier, vol. 1(1), pages 39-56, January.
  10. Evans, G B A & Savin, N E, 1981. "Testing for Unit Roots: 1," Econometrica, Econometric Society, vol. 49(3), pages 753-79, May.
  11. Burmeister, Edwin & Flood, Robert P. & Garber, Peter M., 1983. "On the equivalence of solutions in rational expectations models," Journal of Economic Dynamics and Control, Elsevier, vol. 5(1), pages 311-321, February.
  12. Kenneth D. West, 1986. "A Standard Monetary Model and the Variability of the Deutschemark-DollarExchange Rate," NBER Working Papers 2102, National Bureau of Economic Research, Inc.
  13. Jeffrey R. Shafer & Bonnie E. Loopesko, 1983. "Floating Exchange Rates after Ten years," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 14(1), pages 1-86.
  14. Paul R. Milgrom, 1978. "Rational Expectations," Discussion Papers 406, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  15. Rogoff, Kenneth, 1984. "On the effects of sterilized intervention : An analysis of weekly data," Journal of Monetary Economics, Elsevier, vol. 14(2), pages 133-150, September.
  16. Brunner, Karl & Meltzer, Allan H., 1979. "Policies for employment, prices, and exchange rates," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 11(1), pages 1-7, January.
  17. Peter Isard, 1983. "An Accounting Framework and Some Issues for Modeling How Exchange Rates Respond to the News," NBER Chapters, in: Exchange Rates and International Macroeconomics, pages 19-66 National Bureau of Economic Research, Inc.
  18. Maurice Obstfeld & Robert E. Cumby & John Huizinga, 1983. "Two-Step Two-Stage Least Squares Estimation in Models with Rational Expectations," NBER Technical Working Papers 0011, National Bureau of Economic Research, Inc.
  19. Frenkel, Jacob A, 1981. "Flexible Exchange Rates, Prices, and the Role of "News": Lessons from the 1970s," Journal of Political Economy, University of Chicago Press, vol. 89(4), pages 665-705, August.
  20. Robert P. Flood, 1981. "Explanations of Exchange Rate Volatility and Other Empirical Regularities in Some Popular Models of the Foreign Exchange Market," NBER Working Papers 0625, National Bureau of Economic Research, Inc.
  21. Frankel, Jeffrey A, 1979. "On the Mark: A Theory of Floating Exchange Rates Based on Real Interest Differentials," American Economic Review, American Economic Association, vol. 69(4), pages 610-22, September.
  22. Frankel, Jeffrey A., 1982. "In search of the exchange risk premium: A six-currency test assuming mean-variance optimization," Journal of International Money and Finance, Elsevier, vol. 1(1), pages 255-274, January.
  23. Maurice Obstfeld & Kenneth Rogoff, 1981. "Speculative hyperinflations in a maximizing models: can we rule them out?," International Finance Discussion Papers 195, Board of Governors of the Federal Reserve System (U.S.).
  24. Mussa, Michael, 1979. "Empirical regularities in the behavior of exchange rates and theories of the foreign exchange market," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 11(1), pages 9-57, January.
  25. Deborah J. Danker & Richard A. Haas, 1985. "Small empirical models of exchange market intervention : applications to Germany, Japan, and Canada," Staff Studies 135, Board of Governors of the Federal Reserve System (U.S.).
  26. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
  27. McCallum, Bennett T, 1976. "Rational Expectations and the Natural Rate Hypothesis: Some Consistent Estimates," Econometrica, Econometric Society, vol. 44(1), pages 43-52, January.
  28. Flood, Robert P., 1981. "Explanations of exchange-rate volatility and other empirical regularities in some popular models of the foreign exchange market," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 15(1), pages 219-249, January.
  29. Hakkio, Craig S., 1984. "A re-examination of purchasing power parity : A multi-country and multi-period study," Journal of International Economics, Elsevier, vol. 17(3-4), pages 265-277, November.
  30. Frenkel, Jacob A, 1976. " A Monetary Approach to the Exchange Rate: Doctrinal Aspects and Empirical Evidence," Scandinavian Journal of Economics, Wiley Blackwell, vol. 78(2), pages 200-224.
  31. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
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