Empirical Exchange Rate Models of the Nineties: Are Any Fit to Survive?

49 Pages Posted: 20 Oct 2008

See all articles by Yin-Wong Cheung

Yin-Wong Cheung

City University of Hong Kong - Department of Economics & Finance; University of California, Santa Cruz - Department of Economics; University of California at Santa Cruz - Department of Economics

Menzie David Chinn

University of Wisconsin, Madison - Robert M. La Follette School of Public Affairs and Department of Economics; National Bureau of Economic Research (NBER)

Antonio I. Garcia Pascual

International Monetary Fund (IMF) - Western Hemisphere Department; CESifo (Center for Economic Studies and Ifo Institute)

Multiple version iconThere are 4 versions of this paper

Date Written: June 2003

Abstract

Previous assessments of forecasting performance of exchange rate models have focused upon a narrow set of models typically of the 1970's vintage. The canonical papers in this literature are by Meese and Rogoff (1983, 1988), who examined monetary and portfolio balance models. Succeeding works by Mark (1995) and Chinn and Meese (1995) focused on similar models. In this paper we re-assess exchange rate prediction using a wider set of models that have been proposed in the last decade: interest rate parity, productivity based models, and a composite specification incorporating the real interest differential, portfolio balance and nontradables price channels. The performance of these models is compared against two reference specifications - the purchasing power parity and the Dornbusch-Frankel sticky price monetary model. The models are estimated in error correction and first-difference specifications. Rather than estimating the cointegrating vector over the entire sample and treating it as part of the ex ante information set as is commonly done in the literature, we also update the cointegrating vector, thereby generating true ex ante forecasts. We examine model performance at various forecast horizons (1 quarter, 4 quarters, 20 quarters) using differing metrics (mean squared error, direction of change), as well as the consistency test of Cheung and Chinn (1998). No model consistently outperforms a random walk, by a mean squared error measure; however, along a direction-of-change dimension, certain structural models do outperform a random walk with statistical significance. Moreover, one finds that these forecasts are cointegrated with the actual values of exchange rates, although in a large number of cases, the elasticity of the forecasts with respect to the actual values is different from unity. Overall, model/specification/currency combinations that work well in one period will not necessarily work well in another period.

Keywords: exchange rates, monetary model, productivity, interest rate parity, purchasing power

JEL Classification: F31, F47

Suggested Citation

Cheung, Yin-Wong and Chinn, Menzie David and Garcia Pascual, Antonio I., Empirical Exchange Rate Models of the Nineties: Are Any Fit to Survive? (June 2003). Available at SSRN: https://ssrn.com/abstract=1286206 or http://dx.doi.org/10.2139/ssrn.1286206

Yin-Wong Cheung (Contact Author)

City University of Hong Kong - Department of Economics & Finance ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong

University of California, Santa Cruz - Department of Economics ( email )

435 Engineering 2
Santa Cruz, CA 95064
United States
831-459-4247 (Phone)
831-459-5077 (Fax)

University of California at Santa Cruz - Department of Economics ( email )

1156 High Street
Santa Cruz, CA 95064
United States

Menzie David Chinn

University of Wisconsin, Madison - Robert M. La Follette School of Public Affairs and Department of Economics ( email )

1180 Observatory Drive
Madison, WI 53706-1393
United States
608-262-7397 (Phone)
608-262-2033 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Antonio I. Garcia Pascual

International Monetary Fund (IMF) - Western Hemisphere Department ( email )

700 19th Street NW
Washington, DC 20431
United States

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

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