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Can Parameter Instability Explain the Meese-Rogoff Puzzle?

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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 Swiss National Bank, Study Center Gerzensee in its series Working Papers with number 09.04.

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Length: 55 pages
Date of creation: Aug 2009
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Handle: RePEc:szg:worpap:0904

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  1. Molodtsova, Tanya & Papell, David H., 2009. "Out-of-sample exchange rate predictability with Taylor rule fundamentals," Journal of International Economics, Elsevier, vol. 77(2), pages 167-180, April.
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  6. Carriero, Andrea & Kapetanios, George & Marcellino, Massimiliano, 2008. "Forecasting Exchange Rates with a Large Bayesian VAR," CEPR Discussion Papers 7008, C.E.P.R. Discussion Papers.
  7. Richard Meese & Kenneth Rogoff, 1982. "The out-of-sample failure of empirical exchange rate models: sampling error or misspecification?," International Finance Discussion Papers 204, Board of Governors of the Federal Reserve System (U.S.).
  8. Philippe Bacchetta & Eric Van Wincoop, 2006. "Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?," American Economic Review, American Economic Association, vol. 96(3), pages 552-576, June.
  9. Bacchetta, Philippe & van Wincoop, Eric, 2009. "On the Unstable Relationship between Exchange Rates and Macroeconomic Fundamentals," CEPR Discussion Papers 7309, C.E.P.R. Discussion Papers.
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  14. Philippe Bacchetta & Eric van Wincoop, 2009. "Tacit On the Unstable Relationship between Exchange Rates and Macroeconomic Fundamentals," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 09.07, Université de Lausanne, Faculté des HEC, DEEP.
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Citations

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Cited by:
  1. Philippe Bacchetta & Eric van Wincoop, 2009. "On the Unstable Relationship between Exchange Rates and Macroeconomic Fundamentals," NBER Working Papers 15008, National Bureau of Economic Research, Inc.
  2. Fratzscher, Marcel & Sarno, Lucio & Zinna, Gabriele, 2012. "The scapegoat theory of exchange rates: the first tests," Working Paper Series 1418, European Central Bank.
  3. Park, Cheolbeom & Park, Sookyung, 2013. "Exchange rate predictability and a monetary model with time-varying cointegration coefficients," Journal of International Money and Finance, Elsevier, vol. 37(C), pages 394-410.
  4. Christophe Amat & Tomasz Michalski & Gilles Stoltz, 2014. "Forecasting exchange rates better than the random walk thanks to machine learning techniques," Working Papers halshs-01003914, HAL.
  5. Toni Beutler, 2012. "Forecasting Exchange Rates with Commodity Convenience Yields," Working Papers 12.03, Swiss National Bank, Study Center Gerzensee.
  6. Barbara Rossi, 2013. "Exchange Rate Predictability," Journal of Economic Literature, American Economic Association, vol. 51(4), pages 1063-1119, December.
  7. Joseph P. Byrne & Dimitris Korobilis & Pinho J. Ribeiro, 2014. "Exchange Rate Predictability in a Changing World," Working Paper Series 06_14, The Rimini Centre for Economic Analysis.
  8. 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.
  9. Rossi, Barbara & Sekhposyan, Tatevik, 2011. "Understanding models' forecasting performance," Journal of Econometrics, Elsevier, vol. 164(1), pages 158-172, September.
  10. Travis J. Berge, 2011. "Forecasting disconnected exchange rates," Research Working Paper RWP 11-12, Federal Reserve Bank of Kansas City.
  11. Barbara Rossi, 2011. "Advances in Forecasting Under Instability," Working Papers 11-20, Duke University, Department of Economics.

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