Exchange Rate Models are Not as Bad as You Think

61 Pages Posted: 23 May 2012

See all articles by Charles M. Engel

Charles M. Engel

University of Wisconsin - Madison - Department of Economics; National Bureau of Economic Research (NBER); University of Washington - Department of Economics

Nelson C. Mark

University of Notre Dame - Department of Economics and Econometrics; National Bureau of Economic Research (NBER)

Kenneth D. West

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

Date Written: August 2007

Abstract

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.

Suggested Citation

Engel, Charles M. and Mark, Nelson Chung and West, Kenneth D., Exchange Rate Models are Not as Bad as You Think (August 2007). NBER Working Paper No. w13318. Available at SSRN: https://ssrn.com/abstract=2065144

Charles M. Engel (Contact Author)

University of Wisconsin - Madison - Department of Economics ( email )

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Madison, WI 53706
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National Bureau of Economic Research (NBER)

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University of Washington - Department of Economics ( email )

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Nelson Chung Mark

University of Notre Dame - Department of Economics and Econometrics ( email )

442 Flanner
Notre Dame, IN 46556
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Kenneth D. West

University of Wisconsin - Madison - Department of Economics ( email )

1180 Observatory Drive
Madison, WI 53706
United States
608-262-0033 (Phone)
608-262-2033 (Fax)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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