Real Exchange Rate Forecasting and PPP: This Time the Random Walk Loses

27 Pages Posted: 17 Aug 2015

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: 2015-03-01

Abstract

This paper brings four new insights into the Purchasing Power Parity (PPP) debate. First, we show that a half-life PPP (HL) model is able to forecast real exchange rates better than the random walk (RW) model at both short and long-term horizons. Second, we find that this result holds if the speed of adjustment to the sample mean is calibrated at reasonable values rather than estimated. Third, we find that it is preferable to calibrate, rather than to elicit as a prior, the parameter determining the speed of adjustment to PPP. Fourth, for most currencies in our sample, the HL model outperforms the RW also in terms of nominal effective exchange rate forecasting.

JEL Classification: C32, F31, F37

Suggested Citation

Ca' Zorzi, Michele and Muck, Jakub and Rubaszek, Michal, Real Exchange Rate Forecasting and PPP: This Time the Random Walk Loses (2015-03-01). Globalization and Monetary Policy Institute Working Paper No. 229. Available at SSRN: https://ssrn.com/abstract=2643955 or http://dx.doi.org/10.24149/gwp229

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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