Real Exchange Rate Forecasting: A Calibrated Half-life PPP Model Can Beat the Random Walk

28 Pages Posted: 25 Aug 2013

See all articles by Michele Ca' Zorzi

Michele Ca' Zorzi

European Central Bank (ECB)

Jakub Muck

National Bank of Poland - Department of Economics; Warsaw School of Economics (SGH) - Institute of Econometrics

Michał Rubaszek

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

Date Written: August 5, 2013

Abstract

This paper brings three new insights into the Purchasing Power Parity (PPP) debate. First, we show that a half-life PPP model is able to forecast real exchange rates (RER) better than the random walk (RW) model at both short and long-term horizons. Secondly, we find that this result holds only if the speed of adjustment to the sample mean is calibrated at reasonable values rather than estimated. Finally, we find that it is also preferable to calibrate, rather than to elicit as a prior, the parameter determining the speed of adjustment to PPP.

Keywords: Exchange rate forecasting, purchasing power parity, half-life

JEL Classification: C32, F31, F37

Suggested Citation

Ca' Zorzi, Michele and Muck, Jakub and Rubaszek, Michal, Real Exchange Rate Forecasting: A Calibrated Half-life PPP Model Can Beat the Random Walk (August 5, 2013). ECB Working Paper No. 1576. Available at SSRN: https://ssrn.com/abstract=2305939

Michele Ca' Zorzi (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Jakub Muck

National Bank of Poland - Department of Economics ( email )

00-919 Warsaw
Poland

Warsaw School of Economics (SGH) - Institute of Econometrics ( email )

Niepodleglosci 164
Warsaw, 02-554
Poland

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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