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Application of Taylor Rule Fundamentals in Forecasting Exchange Rates

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  • Joseph Agyapong

    (Faculty of Business, Economics and Social Sciences, Christian-Albrechts-University of Kiel, Olshausenstr. 40, D-24118 Kiel, Germany)

Abstract

This paper examines the effectiveness of the Taylor rule in contemporary times by investigating the exchange rate forecastability of selected four Organisation for Economic Co-operation and Development (OECD) member countries vis-à-vis the U.S. It employs various Taylor rule models with a non-drift random walk using monthly data from 1995 to 2019. The efficacy of the model is demonstrated by analyzing the pre- and post-financial crisis periods for forecasting exchange rates. The out-of-sample forecast results reveal that the best performing model is the symmetric model with no interest rate smoothing, heterogeneous coefficients and a constant. In particular, the results show that for the pre-financial crisis period, the Taylor rule was effective. However, the post-financial crisis period shows that the Taylor rule is ineffective in forecasting exchange rates. In addition, the sensitivity analysis suggests that a small window size outperforms a larger window size.

Suggested Citation

  • Joseph Agyapong, 2021. "Application of Taylor Rule Fundamentals in Forecasting Exchange Rates," Economies, MDPI, vol. 9(2), pages 1-27, June.
  • Handle: RePEc:gam:jecomi:v:9:y:2021:i:2:p:93-:d:579027
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