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Can Parameter Instability Explain the Meese-Rogoff Puzzle?

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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 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. Eric van Wincoop & Philippe Bacchetta, 2003. "Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?," NBER Working Papers 9498, National Bureau of Economic Research, Inc.
  2. 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), Université de Lausanne, Faculté des HEC, DEEP 09.07, Université de Lausanne, Faculté des HEC, DEEP.
  3. Charles Engel & Kenneth D. West, 2005. "Exchange Rates and Fundamentals," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 113(3), pages 485-517, June.
  4. Lucio Sarno & Giorgio Valente, 2009. "Exchange Rates and Fundamentals: Footloose or Evolving Relationship?," Journal of the European Economic Association, MIT Press, MIT Press, vol. 7(4), pages 786-830, 06.
  5. Menzie D. Chinn & Ron Alquist, 2006. "Conventional and Unconventional Approaches to Exchange Rate Modeling and Assessment," NBER Working Papers 12481, National Bureau of Economic Research, Inc.
  6. 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, Elsevier, vol. 53(1), pages 29-52, February.
  7. Carriero, Andrea & Kapetanios, George & Marcellino, Massimiliano, 2008. "Forecasting Exchange Rates with a Large Bayesian VAR," CEPR Discussion Papers, C.E.P.R. Discussion Papers 7008, C.E.P.R. Discussion Papers.
  8. Richard Meese & Kenneth Rogoff & Jacob Frenkel, . "The Out-of-Sample Failure of Empirical Exchange Rate Models: Sampling Error or Misspecification?," Working Paper 32044, Harvard University OpenScholar.
  9. Molodtsova, Tanya & Papell, David H., 2009. "Out-of-sample exchange rate predictability with Taylor rule fundamentals," Journal of International Economics, Elsevier, Elsevier, vol. 77(2), pages 167-180, April.
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  11. Cheung, Yin-Wong & Chinn, Menzie D. & Pascual, Antonio Garcia, 2005. "Empirical exchange rate models of the nineties: Are any fit to survive?," Journal of International Money and Finance, Elsevier, Elsevier, vol. 24(7), pages 1150-1175, November.
  12. J.J.J. Groen, 2001. "(EURO) Exchange Rate Predictability and Monetary Fundamentals in a Small Multi-Country Panel," WO Research Memoranda (discontinued), Netherlands Central Bank, Research Department 664, Netherlands Central Bank, Research Department.
  13. Garry J. Schinasi & P.A.V.B. Swamy, 1987. "The out-of-sample forecasting performance of exchange rate models when coefficients are allowed to change," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 301, Board of Governors of the Federal Reserve System (U.S.).
  14. Barbara Rossi, 2005. "Are Exchange Rates Really Random Walks? Some Evidence Robust to Parameter Instability," International Finance, EconWPA 0503006, EconWPA.
  15. Cheung, Yin-Wong & Chinn, Menzie David, 2001. "Currency traders and exchange rate dynamics: a survey of the US market," Journal of International Money and Finance, Elsevier, Elsevier, vol. 20(4), pages 439-471, August.
  16. Wolff, Christian C P, 1987. "Time-Varying Parameters and the Out-of-Sample Forecasting Performance of Structural Exchange Rate Models," Journal of Business & Economic Statistics, American Statistical Association, American Statistical Association, vol. 5(1), pages 87-97, January.
  17. Yu-Chin Chen & Kenneth Rogoff & Barbara Rossi, 2008. "Can Exchange Rates Forecast Commodity Prices?," NBER Working Papers 13901, National Bureau of Economic Research, Inc.
  18. Kenneth S. Rogoff & Vania Stavrakeva, 2008. "The Continuing Puzzle of Short Horizon Exchange Rate Forecasting," NBER Working Papers 14071, National Bureau of Economic Research, Inc.
  19. 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.
  20. Cerra, Valerie & Saxena, Sweta Chaman, 2010. "The monetary model strikes back: Evidence from the world," Journal of International Economics, Elsevier, Elsevier, vol. 81(2), pages 184-196, July.
  21. Groen, Jan J J, 2005. "Exchange Rate Predictability and Monetary Fundamentals in a Small Multi-country Panel," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 37(3), pages 495-516, June.
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Citations

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Cited by:
  1. Fratzscher, Marcel & Sarno, Lucio & Zinna, Gabriele, 2012. "The scapegoat theory of exchange rates: the first tests," Working Paper Series, European Central Bank 1418, European Central Bank.
  2. Toni Beutler, 2012. "Forecasting Exchange Rates with Commodity Convenience Yields," Working Papers, Swiss National Bank, Study Center Gerzensee 12.03, Swiss National Bank, Study Center Gerzensee.
  3. 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.
  4. 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), Université de Lausanne, Faculté des HEC, DEEP 11.03, Université de Lausanne, Faculté des HEC, DEEP.
  5. Park, Cheolbeom & Park, Sookyung, 2013. "Exchange rate predictability and a monetary model with time-varying cointegration coefficients," Journal of International Money and Finance, Elsevier, Elsevier, vol. 37(C), pages 394-410.
  6. Barbara Rossi, 2013. "Exchange Rate Predictability," Working Papers 690, Barcelona Graduate School of Economics.
  7. Christophe Amat & Tomasz Michalski & Gilles Stoltz, 2014. "Forecasting exchange rates better than the random walk thanks to machine learning techniques," Working Papers, HAL halshs-01003914, HAL.
  8. Byrne, Joseph P & Korobilis, Dimitris & Ribeiro, Pinho J, 2014. "Exchange Rate Predictability in a Changing World," MPRA Paper 53684, University Library of Munich, Germany.
  9. Rossi, Barbara & Sekhposyan, Tatevik, 2011. "Understanding models' forecasting performance," Journal of Econometrics, Elsevier, Elsevier, vol. 164(1), pages 158-172, September.
  10. Barbara Rossi, 2011. "Advances in Forecasting Under Instability," Working Papers, Duke University, Department of Economics 11-20, Duke University, Department of Economics.
  11. Travis J. Berge, 2011. "Forecasting disconnected exchange rates," Research Working Paper, Federal Reserve Bank of Kansas City RWP 11-12, Federal Reserve Bank of Kansas City.

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