Real Exchange Rate Forecasting and PPP: This Time the Random Walk Loses

This paper brings four new insights into the Purchasing Power Parity (PPP) debate. First, we show that a half-life PPP (HL) model is able to forecast real exchange rates better than the random walk (RW) model at both short and long-term horizons. Second, we find that this result holds if the speed o...

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Bibliographic Details
Published inOpen economies review Vol. 27; no. 3; pp. 585 - 609
Main Authors Ca’ Zorzi, Michele, Muck, Jakub, Rubaszek, Michal
Format Journal Article
LanguageEnglish
Published New York Springer US 01.07.2016
Springer Nature B.V
Subjects
Central banks
Development Economics
Economic models
Economic Policy
Economic statistics
Economic theory
Economics
Economics and Finance
European Integration
Exchange rates
Forecasting
Foreign exchange rates
International Economics
Macroeconomics/Monetary Economics//Financial Economics
Probability distribution
Purchasing power parity
Research Article
Studies
Exchange rate forecasting
C32
Half-life
F37
F31
Purchasing power parity
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Summary:This paper brings four new insights into the Purchasing Power Parity (PPP) debate. First, we show that a half-life PPP (HL) model is able to forecast real exchange rates better than the random walk (RW) model at both short and long-term horizons. Second, we find that this result holds if the speed of adjustment to the sample mean is calibrated at reasonable values rather than estimated. Third, we find that it is preferable to calibrate, rather than to elicit as a prior, the parameter determining the speed of adjustment to PPP. Fourth, for most currencies in our sample, the HL model outperforms the RW also in terms of nominal exchange rate forecasting.
Bibliography:ObjectType-Article-1
SourceType-Scholarly Journals-1
ObjectType-Feature-2
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ISSN:0923-7992
1573-708X
DOI:10.1007/s11079-015-9386-4