The Predictive Power of Equilibrium Exchange Rate Models

43 Pages Posted: 10 Jan 2020

See all articles by Michele Ca' Zorzi

Michele Ca' Zorzi

European Central Bank (ECB)

Adam Cap

Bank for International Settlements (BIS)

Andrej Mijakovic

European University Institute

Michał Rubaszek

Warsaw School of Economics (SGH)

Date Written: January, 2020

Abstract

In this paper we evaluate the predictive power of the three most popular equilibrium exchange rate concepts: Purchasing Power Parity (PPP), Behavioral Equilibrium Exchange Rate (BEER) and the Macroeconomic Balance (MB) approach. We show that there is a clear trade-off between storytelling and forecast accuracy. The PPP model offers little economic insights, but has good predictive power. The BEER framework, which links exchange rates to fundamentals, does not deliver forecasts of better quality than PPP. The MB approach has the most appealing economic interpretation, but performs poorly in forecasting terms. Sensitivity analysis confirms that changing the composition of fundamentals in the BEER model or modifying key underlying assumptions in the MB model does not generally enhance their predictive power.

Keywords: equilibrium exchange rate models, forecasting, mean reversion, panel data

JEL Classification: C33, F31, F37, F41

Suggested Citation

Ca' Zorzi, Michele and Cap, Adam and Mijakovic, Andrej and Rubaszek, Michał, The Predictive Power of Equilibrium Exchange Rate Models (January, 2020). ECB Working Paper No. 2358. Available at SSRN: https://ssrn.com/abstract=3516749

Michele Ca' Zorzi

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Adam Cap

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

Andrej Mijakovic (Contact Author)

European University Institute ( email )

Villa Schifanoia
133 via Bocaccio
Firenze (Florence), Tuscany 50014
Italy

Michał Rubaszek

Warsaw School of Economics (SGH) ( email )

aleja Niepodleglosci 162
PL-Warsaw, 02-554
Poland

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