Why is it so Difficult to Beat the Random Walk Forecast of Exchange Rates?

42 Pages Posted: 13 Nov 2001

See all articles by Lutz Kilian

Lutz Kilian

University of Michigan at Ann Arbor - Department of Economics; Centre for Economic Policy Research (CEPR)

Mark P. Taylor

Washington University in St. Louis - John M. Olin Business School; Centre for Economic Policy Research (CEPR)

Date Written: October 2001

Abstract

We propose an exchange rate model that can explain both the observed volatility and the persistence of real and nominal exchange rate movements and thus in some measure resolves Rogoff's (1996) purchasing power parity puzzle. Our analysis reconciles the well-known difficulties in beating the random walk forecast model with the statistical evidence of nonlinear mean reversion in deviations from fundamentals. Our analysis also provides a compelling rationale for the long-horizon predictability of exchange rates. We find strong empirical support for long-horizon predictability, and we explain why it is difficult to exploit this predictability in real-time forecasts. Our results not only lend support to economists' beliefs that the exchange rate is inherently predictable, but they also help us to understand the reluctance of applied forecasters to abandon chartist methods in favor of models based on economic fundamentals.

Keywords: Purchasing power parity, real exchange rate, random walk, economic models of exchange rate determination, long-horizon regression tests

JEL Classification: C53, F31, F47

Suggested Citation

Kilian, Lutz and Taylor, Mark Peter, Why is it so Difficult to Beat the Random Walk Forecast of Exchange Rates? (October 2001). CEPR Discussion Paper No. 3024. Available at SSRN: https://ssrn.com/abstract=290383

Lutz Kilian (Contact Author)

University of Michigan at Ann Arbor - Department of Economics ( email )

611 Tappan Street
Ann Arbor, MI 48109-1220
United States
734-764-2320 (Phone)
734-764-2769 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Mark Peter Taylor

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1156
St. Louis, MO 63130-4899
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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