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Politics and exchange rate forecasts

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  • S. Brock Blomberg
  • Gregory D. Hess

Abstract

Standard exchange rate models perform poorly in out-of-sample forecasting when compared to the random walk model. We posit part of the poor performance of these models may be due to omission of political factors. We test this hypothesis by including political variables that capture party-specific, election-specific and candidate-specific characteristics. Surprisingly, we find our political model outperforms the random walk in out-of-sample forecasting at one to twelve month horizons for the pound/dollar, mark/dollar, pound/mark and the trade-weighted dollar, mark, and pound exchange rates.

Suggested Citation

  • S. Brock Blomberg & Gregory D. Hess, 1996. "Politics and exchange rate forecasts," Research Working Paper 96-02, Federal Reserve Bank of Kansas City.
  • Handle: RePEc:fip:fedkrw:96-02
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    References listed on IDEAS

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    1. Blomberg, S-B & Hess, G-D, 1995. "The Exchange Rate Politics Puzzle," Papers 95-14, Wellesley College - Department of Economics.
    2. Chappell, Henry W, Jr, 1990. "Economic Performance, Voting, and Political Support: A Unified Approach," The Review of Economics and Statistics, MIT Press, vol. 72(2), pages 313-320, May.
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    6. Mark P. Taylor, 1995. "The Economics of Exchange Rates," Journal of Economic Literature, American Economic Association, vol. 33(1), pages 13-47, March.
    7. Alberto Alesina & Nouriel Roubini, 1992. "Political Cycles in OECD Economies," Review of Economic Studies, Oxford University Press, vol. 59(4), pages 663-688.
    8. Bachman, Daniel, 1992. "The effect of political risk on the forward exchange bias: the case of elections," Journal of International Money and Finance, Elsevier, vol. 11(2), pages 208-219, April.
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    10. Sarno,Lucio & Taylor,Mark P., 2003. "The Economics of Exchange Rates," Cambridge Books, Cambridge University Press, number 9780521485845.
    11. Engel, Charles & Hamilton, James D, 1990. "Long Swings in the Dollar: Are They in the Data and Do Markets Know It?," American Economic Review, American Economic Association, vol. 80(4), pages 689-713, September.
    12. 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.
    13. Frenkel, Jacob A. & Mussa, Michael L., 1985. "Asset markets, exchange rates and the balance of payments," Handbook of International Economics,in: R. W. Jones & P. B. Kenen (ed.), Handbook of International Economics, edition 1, volume 2, chapter 14, pages 679-747 Elsevier.
    14. Roubini, Nouriel & Alesina, Alberto, 1992. "Political Cycles in OECD Economies," Scholarly Articles 4553025, Harvard University Department of Economics.
    15. Ayanian, Robert, 1988. "Political Risk, National Defense and the Dollar," Economic Inquiry, Western Economic Association International, vol. 26(2), pages 345-351, April.
    16. Alesina, Alberto, 1987. "Macroeconomic Policy in a Two-party System as a Repeated Game," Scholarly Articles 4552531, Harvard University Department of Economics.
    17. Gartner, Manfred, 1986. "Some political economy of flexible exchange rates," European Journal of Political Economy, Elsevier, vol. 2(2), pages 153-168.
    18. Westerfield, Janice Moulton, 1977. "An examination of foreign exchange risk under fixed and floating rate regimes," Journal of International Economics, Elsevier, vol. 7(2), pages 181-200, May.
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    Citations

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    Cited by:

    1. Blomberg, S. Brock & Hess, Gregory D., 2003. "Is the political business cycle for real?," Journal of Public Economics, Elsevier, vol. 87(5-6), pages 1091-1121, May.
    2. Meon, Pierre-Guillaume, 2001. "A Model of Exchange Rate Crises with Partisan Governments," Journal of Macroeconomics, Elsevier, vol. 23(4), pages 517-535, October.
    3. John R. Freeman & Jude C. Hays & Helmut Stix, 1999. "Democracy and Markets: The Case of Exchange Rates," Working Papers 39, Oesterreichische Nationalbank (Austrian Central Bank).
    4. Helge Berger & Jan-Egbert Sturm & Jakob de Haan, 2000. "An Empirical Investigation into Exchange Rate Regime Choice and Exchange Rate Volatility," CESifo Working Paper Series 263, CESifo Group Munich.
    5. Clark, Todd E. & McCracken, Michael W., 2001. "Tests of equal forecast accuracy and encompassing for nested models," Journal of Econometrics, Elsevier, vol. 105(1), pages 85-110, November.
    6. S. Brock Blomberg, 2001. ""Dumb And Dumber" Explanations For Exchange Rate Dynamics," Journal of Applied Economics, Universidad del CEMA, vol. 4, pages 187-216, November.
    7. Kauffman, Kyle & Weerapana, Akila, 2006. "The Impact of AIDS-Related News on Exchange Rates in South Africa," Economic Development and Cultural Change, University of Chicago Press, vol. 54(2), pages 349-368, January.
    8. Ernesto H. Stein & Jeffry Frieden & Piero Ghezzi, 2000. "Politics and Exchange Rates: A Cross-Country Approach to Latin America," Research Department Publications 3119, Inter-American Development Bank, Research Department.
    9. Fratzscher, Marcel & Stracca, Livio, 2009. "Does it pay to have the euro? Italy’s politics and financial markets under the lira and the euro," Working Paper Series 1064, European Central Bank.
    10. Iljoong Kim & Inbae Kim, 2005. "Endogenous changes in the exchange rate regime: A bureaucratic incentive model," Public Choice, Springer, vol. 125(3), pages 339-361, December.
    11. Takao FUKUCHI & Suminori TOKUNAGA, 1999. "Simulation Analysis Of Exchange Rate Dynamics: The Case Of Indonesia," The Developing Economies, Institute of Developing Economies, vol. 37(1), pages 35-58, March.
    12. Daniel MITCHELL RESTREPO, 2006. "Forecasting the Colombian Exchange Rate: Capital Adjustments and Politics vs. Traditional IRP, Trade Adjustments and Random Walk Frameworks," ARCHIVOS DE ECONOMÍA 011228, DEPARTAMENTO NACIONAL DE PLANEACIÓN.
    13. repec:onb:oenbwp:y::i:39:b:1 is not listed on IDEAS
    14. Gregory D. Hess & Mark E. Schweitzer, 2000. "Does wage inflation cause price inflation?," Policy Discussion Papers, Federal Reserve Bank of Cleveland, issue Apr.
    15. S. Brock Blomberg & Jeffry Frieden & Ernesto Stein, 2005. "Sustaining fixed rates: The political economy of currency pegs in Latin America," Journal of Applied Economics, Universidad del CEMA, vol. 8, pages 203-225, November.
    16. Mashkoor, Asim & Ahmed, Ovais & Herani, Dr. Gobin, 2015. "The relationship between Foreign Currency trading and Economic Development: A case Study of Pakistan," MPRA Paper 64482, University Library of Munich, Germany.

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    Keywords

    Foreign exchange rates ; Political science;

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