Integration, Cointegration and the Forecast Consistency of Structural Exchange Rate Models

Abstract:     
Exchange rate forecasts are generated using some popular monetary models of exchange rates, in conjunction with several estimation techniques. We propose an alternative set of criteria for evaluating forecast rationality, which entails the following requirements: the forecast and the actual series i) have the same order of integration, ii) are cointegrated, and iii) have a cointegrating vector consistent with long run unitary elasticity of expectations. When these conditions hold, we consider the forecasts to be "consistent." These criteria appear to be more appropriate for forecasts generated by structural models than typical measures of forecast rationality, since such models rely upon serially correlated measures of the fundamentals. We find that it is fairly easy for the generated forecasts to pass the first requirement of consistency that the series be of the same order of integration. However, cointegration fails to hold the farther out the forecasts extend. At the one year ahead horizon, most series and their respective forecasts do not appear cointegrated. Finally, of the cointegrated pairs, the restriction of unitary elasticity of forecasts with respect to actual appears not to be rejected in general. The exception to this pattern is in the case of the error correction models in the longer subsample.

JEL Classification: F31, C32

working papers series