Working Paper

Real exchange rate forecasting and ppp: this time the random walk loses

Abstract: 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 effective exchange rate forecasting.

JEL Classification: C32; F31; F37;

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Bibliographic Information

Provider: Federal Reserve Bank of Dallas

Part of Series: Globalization Institute Working Papers

Publication Date: 2015-03-01

Number: 229

Pages: 27 pages

Note: Published as: Ca' Zorzi, Michele, Jakub Muck and Michal Rubaszek (2015), "Real Exchange Rate Forecasting and PPP: This Time the Random Walk Loses," Open Economies Review 27 (3): 585-609.