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

See all articles by Michele Ca' Zorzi

Michele Ca' Zorzi

European Central Bank (ECB)

Michał Rubaszek

National Bank of Poland; Warsaw School of Economics (SGH)

Date Written: October 1, 2012

Abstract

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

Ca' Zorzi, Michele and Rubaszek, Michal, Real Exchange Rate Forecasting: A Calibrated Half-Life PPP Model Can Beat the Random Walk (October 1, 2012). National Bank of Poland Working Paper No. 123. Available at SSRN: https://ssrn.com/abstract=2163504 or http://dx.doi.org/10.2139/ssrn.2163504

Michele Ca' Zorzi (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Michal Rubaszek

National Bank of Poland ( email )

00-919 Warsaw
Poland

Warsaw School of Economics (SGH) ( email )

aleja Niepodleglosci 162
PL-Warsaw, 02-554
Poland

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