Paper #1369

Title:

Exchange rate predictability

Author:

Barbara Rossi

Date:

February 2013

Abstract:

The main goal of this article is to provide an answer to the question: "Does anything forecast exchange rates, and if so, which variables?". It is well known that exchange rate fluctuations are very difficult to predict using economic models, and that a random walk forecasts exchange rates better than any economic model (the Meese and Rogoff puzzle). However, the recent literature has identified a series of fundamentals/methodologies that claim to have resolved the puzzle. This article provides a critical review of the recent literature on exchange rate forecasting and illustrates the new methodologies and fundamentals that have been recently proposed in an up- to-date, thorough empirical analysis. Overall, our analysis of the literature and the data suggests that the answer to the question: "Are exchange rates predictable?" is, "It depends" -on the choice of predictor, forecast horizon, sample period, model, and forecast evaluation method. Predictability is most apparent when one or more of the following hold: the predictors are Taylor rule or net foreign assets, the model is linear, and a small number of parameters are estimated. The toughest benchmark is the random walk without drift.

Keywords:

Exchange Rates, Forecasting, Instability, Forecast Evaluation.

JEL codes:

F3, C5

Area of Research:

Macroeconomics and International Economics

Published in:

Journal of Economic Literature, 51 (4), 1063-1119, December 2013

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