Real Exchange Rate Forecasting: A Calibrated Half-Life PPP Model Can Beat the Random Walk
National Bank of Poland Working Paper No. 123
21 Pages Posted: 19 Oct 2012 Last revised: 8 Jul 2016
Date Written: October 1, 2012
This paper brings two new insights into the Purchasing Power Parity (PPP) debate. First, even if PPP is thought to hold only in the long run, we show that a half-life PPP model outperforms the random walk in real exchange rate forecasting, also at short-term horizons. Second, we show that this result holds as long as the speed of adjustment to the sample mean is imposed and not estimated. The reason is that the estimation error of the pace of convergence distorts the results in favor of the random walk model, even if the PPP holds in the long-run.
Keywords: exchange rate forecasting, purchasing power parity, half-life
JEL Classification: C32, F31, F37
Suggested Citation: Suggested Citation