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

47 Pages Posted: 19 Dec 2002 Last revised: 2 Sep 2022

See all articles by Yin-Wong Cheung

Yin-Wong Cheung

University of California, Santa Cruz - Department of Economics

Menzie David Chinn

University of Wisconsin, Madison - Robert M. La Follette School of Public Affairs and Department of Economics; National Bureau of Economic Research (NBER)

Antonio I. Garcia Pascual

International Monetary Fund (IMF) - Western Hemisphere Department; CESifo (Center for Economic Studies and Ifo Institute)

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Date Written: December 2002

Abstract

Previous assessments of nominal exchange rate determination have focused upon a narrow set of models typically of the 1970's vintage. The canonical papers in this literature are by Meese and Rogoff (1983, 1988), who examined monetary and portfolio balance models. Succeeding works by Mark (1995) and Chinn and Meese (1995) focused on similar models. In this paper 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 behavioral equilibrium exchange rate' models. The performance of these models is compared against a benchmark model the Dornbusch-Frankel sticky price monetary model. The models are estimated in error correction and first-difference specifications. Rather than estimating the cointegrating vector over the entire sample and treating it as part of the ex ante information set as is commonly done in the literature, we recursively update the cointegrating vector, thereby generating true ex ante forecasts. We examine model performance at various forecast horizons (1 quarter, 4 quarters, 20 quarters) using differing metrics (mean squared error, direction of change), as well as the consistency' test of Cheung and Chinn (1998). No model consistently outperforms a random walk, by a mean squared error measure; however, along a direction-of-change dimension, certain structural models do outperform a random walk with statistical significance. Moreover, one finds that these forecasts are cointegrated with the actual values of exchange rates, although in a large number of cases, the elasticity of the forecasts with respect to the actual values is different from unity. Overall, model/specification/currency combinations that work well in one period will not necessarily work well in another period.

Suggested Citation

Cheung, Yin-Wong and Chinn, Menzie David and Garcia Pascual, Antonio I., Empirical Exchange Rate Models of the Nineties: Are Any Fit to Survive? (December 2002). NBER Working Paper No. w9393, Available at SSRN: https://ssrn.com/abstract=362075

Yin-Wong Cheung

University of California, Santa Cruz - Department of Economics ( email )

Engineering 2, Department of Economics
University of California
Santa Cruz, CA 95064
United States
831-459-5077 (Fax)

Menzie David Chinn (Contact Author)

University of Wisconsin, Madison - Robert M. La Follette School of Public Affairs and Department of Economics ( email )

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Madison, WI 53706-1393
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608-262-2033 (Fax)

National Bureau of Economic Research (NBER)

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Antonio I. Garcia Pascual

International Monetary Fund (IMF) - Western Hemisphere Department ( email )

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United States

CESifo (Center for Economic Studies and Ifo Institute)

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