Can Parameter Instability Explain the Meese-Rogoff Puzzle?

56 Pages Posted: 26 Aug 2009

See all articles by Philippe Bacchetta

Philippe Bacchetta

University of Lausanne; Centre for Economic Policy Research (CEPR); Swiss Finance Institute

Toni Beutler

Study Center Gerzensee; Faculty of Business and Economics, University of Lausanne

Eric van Wincoop

University of Virginia - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: July 2009

Abstract

The empirical literature on nominal exchange rates shows that the current exchange rate is often a better predictor of future exchange rates than a linear combination of macroeconomic fundamentals. This result is behind the famous Meese-Rogoff puzzle. In this paper we evaluate whether parameter instability can account for this puzzle. We consider a theoretical reduced-form relationship between the exchange rate and fundamentals in which parameters are either constant or time varying. We calibrate the model to data for exchange rates and fundamentals and conduct the exact same Meese-Rogoff exercise with data generated by the model. Our main finding is that the impact of time-varying parameters on the prediction performance is either very small or goes in the wrong direction. To help interpret the findings, we derive theoretical results on the impact of time-varying parameters on the out-of-sample forecasting performance of the model. We conclude that it is not time-varying parameters, but rather small sample estimation bias, that explains the Meese-Rogoff puzzle.

Keywords: Exchange rate forecasting, exchange rate models

JEL Classification: F31, F37, F41

Suggested Citation

Bacchetta, Philippe and Beutler, Toni and van Wincoop, Eric, Can Parameter Instability Explain the Meese-Rogoff Puzzle? (July 2009). CEPR Discussion Paper No. DP7383, Available at SSRN: https://ssrn.com/abstract=1462012

Philippe Bacchetta (Contact Author)

University of Lausanne ( email )

Faculty of Business and Economics
Internef 523
1015 Lausanne
Switzerland

HOME PAGE: http://www.hec.unil.ch/pbacchetta/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Faculty of Business and Economics, University of Lausanne ( email )

BFSH1
Lausanne, 1015
Switzerland

Eric Van Wincoop

University of Virginia - Department of Economics ( email )

Rouss Hall 114
P.O. Box 400182
Charlottesville, VA 22904-4182
United States
804-924-3997 (Phone)
804-982-2904 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
2
Abstract Views
447
PlumX Metrics