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Conventional and Unconventional Approaches to Exchange Rate Modeling and Assessment

  • Menzie D. Chinn
  • Ron Alquist

We examine the relative predictive power of the sticky price monetary model, uncovered interest parity, and a transformation of net exports and net foreign assets. In addition to bringing Gourinchas and Rey's new approach and more recent data to bear, we implement the Clark and West (forthcoming) procedure for testing the significance of out-of-sample forecasts. The interest rate parity relation holds better at long horizons and the net exports variable does well in predicting exchange rates at short horizons in-sample. In out-of-sample forecasts, we find evidence that our proxy for Gourinchas and Rey's measure of external imbalances outperforms a random walk at short horizons as do some of other models, although no single model uniformly outperforms the random walk forecast.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12481.

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Date of creation: Aug 2006
Date of revision:
Publication status: published as Ron Alquist & Menzie D. Chinn, 2008. "Conventional and unconventional approaches to exchange rate modelling and assessment," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 13(1), pages 2-13.
Handle: RePEc:nbr:nberwo:12481
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  1. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, vol. 10(3), pages 335-359.
  2. Yin-Wong Cheung & Menzie D. Chinn & Antonio Garcia-Pascual, 2005. "Empirical Exchange Rate Models of the Nineties: Are Any Fit to Survive?," Working Papers 122005, Hong Kong Institute for Monetary Research.
  3. Bernd Schnatz & Focco Vijsellaar & Chiara Osbat, 2004. "Productivity and the Euro-Dollar exchange rate," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 140(1), pages 1-30, March.
  4. Francis X. Diebold & Robert S. Mariano, 1994. "Comparing Predictive Accuracy," NBER Technical Working Papers 0169, National Bureau of Economic Research, Inc.
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  6. John H. Cochrane, 1988. "Production Based Asset Pricing," NBER Working Papers 2776, National Bureau of Economic Research, Inc.
  7. Schnatz, Bernd & Vijselaar, Focco & Osbat, Chiara, 2003. "Productivity and the ('synthetic') euro-dollar exchange rate," Working Paper Series 0225, European Central Bank.
  8. Molodtsova, Tanya & Papell, David H., 2009. "Out-of-sample exchange rate predictability with Taylor rule fundamentals," Journal of International Economics, Elsevier, vol. 77(2), pages 167-180, April.
  9. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
  10. Menzie D. Chinn & Guy Meredith, 2004. "Monetary Policy and Long-Horizon Uncovered Interest Parity," IMF Staff Papers, Palgrave Macmillan, vol. 51(3), pages 409-430, November.
  11. Helene Rey & Pierre Olivier Gourinchas, 2005. "International Financial Adjustment," 2005 Meeting Papers 169, Society for Economic Dynamics.
  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. Charles Engel & Kenneth D. West, 2005. "Exchange Rates and Fundamentals," Journal of Political Economy, University of Chicago Press, vol. 113(3), pages 485-517, June.
  14. Clark, Todd E. & West, Kenneth D., 2006. "Using out-of-sample mean squared prediction errors to test the martingale difference hypothesis," Journal of Econometrics, Elsevier, vol. 135(1-2), pages 155-186.
  15. Nautz, Dieter & Offermanns, Christian J., 2006. "Does the Euro follow the German Mark? Evidence from the monetary model of the exchange rate," European Economic Review, Elsevier, vol. 50(5), pages 1279-1295, July.
  16. Stock, James H & Watson, Mark W, 1993. "A Simple Estimator of Cointegrating Vectors in Higher Order Integrated Systems," Econometrica, Econometric Society, vol. 61(4), pages 783-820, July.
  17. Stockman, Alan C, 1980. "A Theory of Exchange Rate Determination," Journal of Political Economy, University of Chicago Press, vol. 88(4), pages 673-98, August.
  18. Faust, Jon & Rogers, John H. & H. Wright, Jonathan, 2003. "Exchange rate forecasting: the errors we've really made," Journal of International Economics, Elsevier, vol. 60(1), pages 35-59, May.
  19. West, K.D., 1994. "Asymptotic Inference About Predictive Ability," Working papers 9417, Wisconsin Madison - Social Systems.
  20. Frankel, Jeffrey A, 1979. "On the Mark: A Theory of Floating Exchange Rates Based on Real Interest Differentials," American Economic Review, American Economic Association, vol. 69(4), pages 610-22, September.
  21. Richard Clarida & Lucio Sarno & Mark Taylor & Giorgio Valente, 2001. "The Out-of-Sample Success of Term Structure Models as Exchange Rate Predictors: A Step Beyond," NBER Working Papers 8601, National Bureau of Economic Research, Inc.
  22. Mark, Nelson C, 1995. "Exchange Rates and Fundamentals: Evidence on Long-Horizon Predictability," American Economic Review, American Economic Association, vol. 85(1), pages 201-18, March.
  23. Chinn, Menzie D & Alquist, Ron, 2000. "Tracking the Euro's Progress," International Finance, Wiley Blackwell, vol. 3(3), pages 357-73, November.
  24. McCracken, Michael W & Sapp, Stephen G, 2005. "Evaluating the Predictability of Exchange Rates Using Long-Horizon Regressions: Mind Your p's and q's!," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 37(3), pages 473-94, June.
  25. MacDonald, Ronald & Taylor, Mark P., 1994. "The monetary model of the exchange rate: long-run relationships, short-run dynamics and how to beat a random walk," Journal of International Money and Finance, Elsevier, vol. 13(3), pages 276-290, June.
  26. Fagan, Gabriel & Henry, Jérôme & Mestre, Ricardo, 2001. "An area-wide model (AWM) for the euro area," Working Paper Series 0042, European Central Bank.
  27. Guy Meredith & Menzie D. Chinn, 1998. "Long-Horizon Uncovered Interest Rate Parity," NBER Working Papers 6797, National Bureau of Economic Research, Inc.
  28. Groen, Jan J. J., 2000. "The monetary exchange rate model as a long-run phenomenon," Journal of International Economics, Elsevier, vol. 52(2), pages 299-319, December.
  29. Chinn, Menzie D. & Meese, Richard A., 1995. "Banking on currency forecasts: How predictable is change in money?," Journal of International Economics, Elsevier, vol. 38(1-2), pages 161-178, February.
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