Exchange-rate models.

• Author: Engel, Charles

Recent research that my co-authors and I have undertaken, as well as related research by other NBER researchers, suggests that theoretical models of foreign exchange rates are "not as bad as you think." Since the 1970s, models have emphasized the role of exchange rates as asset prices. The new work, looking at present-value models of exchange rates, highlights the role of expectations in determining exchange rate movements. In this article, I briefly summarize some of the work that I have been involved with, along with a few related papers by other researchers. I also report on some research that has drawn the implications of this new work on exchange rates for open-economy macroeconomic policy.

Should Exchange Rate Models Out-predict the Random Walk Model?

For many years, the standard criterion for judging exchange rate models has been, do they beat the random-walk model for forecasting changes in exchange rates? This criterion was popularized by the seminal work of Meese and Rogoff. (1) They found that the empirical exchange rate models of the 1970s that seemed to fit very well in-sample tended to have a very poor out-of-sample fit. The mean-squared error of the model's prediction of the exchange rate (using realized values of the explanatory variables) tended to be lower than the mean-squared error of the naive model that predicts no change in the exchange rate. While Meese and Rogoff's exercise was not strictly speaking "forecasting" (because it used realized explanatory variables to "predict" the exchange rate), subsequent work has evaluated exchange rate models by the criterion of whether they produce forecasts with a lower mean-squared error than the simple random walk forecast of no change. Mark's (1995) paper was important in reviving interest in empirical exchange rate models. (2) He found that the models were helpful in predicting exchange rates at long horizons. Subsequent work has cast doubt on whether exchange rates can be forecast at long horizons, so there is a weak consensus that the models are not very helpful in forecasting. (It is worth noting that there is a contingent that believes that non-linear models have forecasting power. When exchange rates are far out of line with the fundamentals, the models are useful in predicting that the exchange rate will return to its fundamental level.)

West and I (3) question the standard criterion for judging exchange rate models. Many exchange rate models can be written so that they explain the exchange rate as a weighted sum of current "fundamentals" (such as money supplies, prices, output levels) and the expected future value of the exchange rate. The models actually put relatively little weight on the current fundamentals and much more weight on expectations. The realization of the current fundamental may affect the exchange rate indirectly by influencing the expected future exchange rate. But markets use many sources of information to form expectations of the future exchange rate, not just the realizations of the current fundamentals. So, the models imply that innovations in the current fundamental may not have a large effect on the exchange rate.

This type of model can be solved forward to express the exchange rate as the expected present discounted value of current and future fundamentals. West and...