Testing the Taylor Model Predictability for Exchange Rates in Latin Americ

Exchange rates forecasting performance is tested by a model which incorporates endogenous monetary policy through a Taylor rule reaction function. Other usual monetary and equilibrium empirical exchange rate models are also evaluated for comparison purposes. Predictability is tested by comparing the models to a benchmark random-walk specification. We contribute to the recent literature in many ways. First, we include models of forward looking endogenous monetary policy to the exchange rate forecasting exercise, the Taylor Model. Second, our data, set across countries, is uniform in terms of economies adopting both inflation targeting and flexible exchange rate. Third, our study sheds light on exchange rate determinants for emerging economies: Brazil, Chile, Colombia, Peru and Mexico. Despite the increasing economic importance of this group of countries, studies about them are in relatively short supply. Our results show strong predictability evidence for the Taylor Model and indicate that assuming models of endogenous monetary policy and present value of expected fundamentals is a rewarding strategy to model exchange rate determination.