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Are Exchange Rates Really Random Walks? Some Evidence Robust To Parameter Instability

  • ROSSI, BARBARA

Many authors have documented that it is challenging to explain exchange rate fluctuations with macroeconomic fundamentals: a random walk forecasts future exchange rates better than existing macroeconomic models. This paper applies newly developed tests for nested model that are robust to the presence of parameter instability. The empirical evidence shows that for some countries we can reject the hypothesis that exchange rates are random walks. This raises the possibility that economic models were previously rejected not because the fundamentals are completely unrelated to exchange rate fluctuations, but because the relationship is unstable over time and, thus, difficult to capture by Granger Causality tests or by forecast comparisons. We also analyze forecasts that exploit the time variation in the parameters and find that, in some cases, they can improve over the random walk.

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Article provided by Cambridge University Press in its journal Macroeconomic Dynamics.

Volume (Year): 10 (2006)
Issue (Month): 01 (February)
Pages: 20-38

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Handle: RePEc:cup:macdyn:v:10:y:2006:i:01:p:20-38_05
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  18. 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.
  19. Rossi, Barbara, 2002. "Optimal Tests for Nested Model Selection with Underlying Parameter Instability," Working Papers 02-05, Duke University, Department of Economics.
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