A generalized uncovered interest parity model of exchange rates

Sticky price monetary models of exchange rates, while reasonable theoretically, have been disappointing empirically. Out-of-sample predictions have been little or no better than those from a naive model of no change. The most likely reason is that shocks to the market's expectation of the future equilibrium real exchange rate weaken the stability of the association between exchange rates and the real interest rate differentials. This study identifies three types of shocks that appear to be empirically important. These are productivity growth, which changes the relative price of traded goods at home versus abroad, government budget deficits, and the real price of oil. ; These factors along with real interest rates are shown to explain at least 80 percent of the longer run variation in both the trade-weighted dollar and bilateral rates against the dollar. An error correction model that includes these factors is shown to have out-of-sample prediction errors for changes in the trade-weighted dollar that are 30 to 45 percent lower than those from a naive model of no change, at horizons of four to eight quarters. The prediction errors for bilateral rates against the dollar are almost as low.