Exchange Rate Models Are Not as Bad as You Think

Charles Engel, Nelson C. Mark, Kenneth D. West

NBER Working Paper No. 13318
Issued in August 2007
NBER Program(s):International Finance and Macroeconomics, Monetary Economics

Standard models of exchange rates, based on macroeconomic variables such as prices, interest rates, output, etc., are thought by many researchers to have failed empirically. We present evidence to the contrary. First, we emphasize the point that "beating a random walk" in forecasting is too strong a criterion for accepting an exchange rate model. Typically models should have low forecasting power of this type. We then propose a number of alternative ways to evaluate models. We examine in-sample fit, but emphasize the importance of the monetary policy rule, and its effects on expectations, in determining exchange rates. Next we present evidence that exchange rates incorporate news about future macroeconomic fundamentals, as the models imply. We demonstrate that the models might well be able to account for observed exchange-rate volatility. We discuss studies that examine the response of exchange rates to announcements of economic data. Then we present estimates of exchange-rate models in which expected present values of fundamentals are calculated from survey forecasts. Finally, we show that out-of-sample forecasting power of models can be increased by focusing on panel estimation and long-horizon forecasts.

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Document Object Identifier (DOI): 10.3386/w13318

Published: Exchange Rate Models Are Not As Bad As You Think, Charles Engel, Nelson C. Mark, Kenneth D. West. in NBER Macroeconomics Annual 2007, Volume 22, Acemoglu, Rogoff, and Woodford. 2008

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