Empirical Exchange Rate Models of the Nineties: Are Any Fit to Survive?

Abstract

This working paper was written by Yin-wong Cheung (University of California, Santa Cruz), Menzie D. Chinn (University of Wisconsin and NBER) and Antonio Garcia-Pascual (International Monetary Fund and University of Munich).

We re-assess exchange rate prediction using a wider set of models that have been proposed in the last decade: interest rate parity, productivity based models, and a composite specification. The performance of these models is compared against two reference specifications - purchasing power parity and the sticky price monetary model. The models are estimated in first-difference and error correction specifications, and model performance evaluated at forecast horizons of 1, 4 and 20 quarters, using the mean squared error, direction of change metrics, and the "consistency" test of Cheung and Chinn (1998). Overall, model/specification/currency combinations that work well in one period do not necessarily work well in another period.

Keywords: exchange rates, monetary model, productivity, interest rate parity, behavioral equilibrium exchange rate model, forecasting performance

JEL Classification: F31, F47