Exchange rate models are not as bad as you think
By: Charles Engel, Nelson C. Mark, Kenneth D. West.
Contributors: Mark, Nelson C. 1955-; West, Kenneth D.; National Bureau of Economic Research.
Series: NBER working paper series -- no. 13318.; Working paper series (National Bureau of Economic Research) -- working paper no. 13318.
Publisher: National Bureau of Economic Research
Published: 2007
Place of publication: Cambridge, Mass
Language: eng
Number of pages: 48
Subjects: Foreign exchange rates -- Econometric models -- Evaluation; Foreign exchange rates -- Forecasting
Description: Standard models of exchange rates, based on macroeconomic variables such as prices, interest rates, output, etc., are thought by many researchers to have failed empirically. We present evidence to the contrary. First, we emphasize the point that "beating a random walk" in forecasting is too strong a criterion for accepting an exchange rate model. Typically models should have low forecasting power of this type. We then propose a number of alternative ways to evaluate models. We examine in-sample fit, but emphasize the importance of the monetary policy rule, and its effects on expectations, in determining exchange rates. Next we present evidence that exchange rates incorporate news about future macroeconomic fundamentals, as the models imply. We demonstrate that the models might well be able to account for observed exchange-rate volatility. We discuss studies that examine the response of exchange rates to announcements of economic data. Then we present estimates of exchange-rate models in which expected present values of fundamentals are calculated from survey forecasts. Finally, we show that out-of-sample forecasting power of models can be increased by focusing on panel estimation and long-horizon forecasts.
Notes: "August 2007"

Includes bibliographical references (p. 46-48).

Also available in PDF from the NBER world wide web site (www.nber.org).