Exchange Rate Forecasting with DSGE Models

49 Pages Posted: 18 Jun 2016

See all articles by Michele Ca' Zorzi

Michele Ca' Zorzi

European Central Bank (ECB)

Marcin Kolasa

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

Michał Rubaszek

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

Date Written: June 16, 2016

Abstract

We run a real exchange rate forecasting "horse race", which highlights that two principles hold. First, forecasts should not replicate the high volatility of exchange rates observed in sample. Second, models should exploit the mean reversion of the real exchange rate over long horizons. Abiding by these principles, an open-economy DSGE model performs well in real exchange rate forecasting. However, it fails to forecast nominal exchange rates better than the random walk. We find that the root cause is its inability to predict domestic and foreign inflation. This shortcoming leads us toward simpler ways to outperform the random walk.

Keywords: forecasting, exchange rates, new open economy macroeconomics, mean reversion

JEL Classification: C32, F31, F37

Suggested Citation

Ca' Zorzi, Michele and Kolasa, Marcin and Rubaszek, Michal, Exchange Rate Forecasting with DSGE Models (June 16, 2016). ECB Working Paper No. 1905. Available at SSRN: https://ssrn.com/abstract=2796596

Michele Ca' Zorzi (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Marcin Kolasa

National Bank of Poland ( email )

00-919 Warsaw
Poland

Warsaw School of Economics (SGH) ( email )

aleja Niepodleglosci 162
PL-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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