EMPIRICAL EXCHANGE RATE MODELS OF THE SEVENTIES.pdf

Journal of International Economics 14 (1983) 3-24. North-Holland Publishing Company E M P I R I C A L E X C H A N G E R A T E M O D E L S O F T H E S E V E N T I E S Do they fit out of sample? Richard A. M E E S E * University of California at Berkeley, Berkeley, CA 94720, USA Kenne th R O G O F F Board of Governors of the Federal Reserve System, Washington, DC 20551, USA Received July 1981, revised version received April 1982 This study compares the out-of-sample forecasting accuracy of various structural and time series exchange rate models. We find that a random walk model performs as well as any estimated model at one to twelve month horizons for the dollar/pound, dollar/mark, dollar/yen and trade- weighted dollar exchange rates. The candidate structural models include the flexible-price (Frenkel- Bilson) and sticky-price (Dornbusch-Frankel) monetary models, and a sticky-price model which incorporates the current account (Hooper-Morton). The structural models perform poorly despite the fact that we base their forecasts on actual realized values of future explanatory variables. 1. Introduction This study compares time series and structural models of exchange rates on the basis of their out-of-sample forecasting accuracy. We find that a r andom walk model would have predicted major -count ry exchange rates dur ing the recent f loat ing-rate period as well as any of our candidate models, x Significantly, the structural models fail to improve on the r andom walk model in spite of the fact that we base their forecasts on actual realized values of future explanatory variables. *Both authors were at the Federal Reserve Board when this paper was written. This paper is a revised version of a paper presented at the International Monetary Fund and at the December 1981 Meetings of the Econometric Society. Robert Flood, Jeffrey Frankel, Robert Hodrick, Peter Hooper, and Julio Rotemberg gave us helpful comments on an e