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A new approach to forecasting exchange rates

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  • Clements, Kenneth W.
  • Lan, Yihui

Abstract

Building on purchasing power parity theory, this paper proposes a new approach to forecasting exchange rates using the Big Mac data from The Economist magazine. Our approach is attractive in three aspects. Firstly, it uses easily-available Big Mac prices as input. These prices avoid several potential problems associated with broad price indexes, such as the consumer price index used in conventional PPP studies. Secondly, this approach provides real-time exchange-rate forecasts at any forecast horizon. These high-frequency forecasts could be appealing to those who want up-to-date exchange-rate forecasts. Finally, as our forecasts are obtained through a simulation procedure, estimation uncertainty is made explicit in our framework that provides the entire distribution of exchange rates, not just a single point estimate. Using exchange rates of six major currencies to illustrate the approach, we compare the Big Mac forecasts with those derived from a random walk and the CPI and find some support for our approach, especially at longer term horizons.

Suggested Citation

  • Clements, Kenneth W. & Lan, Yihui, 2010. "A new approach to forecasting exchange rates," Journal of International Money and Finance, Elsevier, vol. 29(7), pages 1424-1437, November.
  • Handle: RePEc:eee:jimfin:v:29:y:2010:i:7:p:1424-1437
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    3. Clements, Kenneth & Lan, Yihui & Roberts, John, 2008. "Exchange-rate economics for the resources sector," Resources Policy, Elsevier, vol. 33(2), pages 102-117, June.
    4. Hertrich, Markus, 2020. "Foreign exchange interventions under a one-sided target zone regime and the Swiss franc," Discussion Papers 21/2020, Deutsche Bundesbank.
    5. Shaghayegh KORDNOORI & Hamidreza MOSTAFAEI & Shirin KORDNOORI, 2015. "Applied SCGM(1,1)c Model and Weighted Markov Chain for Exchange Rate Ratios," Hyperion Economic Journal, Faculty of Economic Sciences, Hyperion University of Bucharest, Romania, vol. 3(4), pages 12-22, December.
    6. Alejandro Parot & Kevin Michell & Werner D. Kristjanpoller, 2019. "Using Artificial Neural Networks to forecast Exchange Rate, including VAR‐VECM residual analysis and prediction linear combination," Intelligent Systems in Accounting, Finance and Management, John Wiley & Sons, Ltd., vol. 26(1), pages 3-15, January.
    7. Duc Hong Vo & Anh The Vo, 2017. "Currency evaluation using a big mac index for Thailand – lessons for Vietnam," Economics Bulletin, AccessEcon, vol. 37(2), pages 999-1011.

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    More about this item

    Keywords

    Exchange-rate forecasting Big Mac prices Purchasing power parity Simulation;

    JEL classification:

    • F30 - International Economics - - International Finance - - - General
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods

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