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ARE EXCHANGE RATES REALLY RANDOM WALKS? SOME EVIDENCE ROBUST TO PARAMETER INSTABILITY

Published online by Cambridge University Press:  14 December 2005

BARBARA ROSSI
BARBARA ROSSI
Affiliation:
Duke University
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Abstract

Many authors have documented that it is challenging to explain exchange rate fluctuations with macroeconomic fundamentals: a random walk forecasts future exchange rates better than existing macroeconomic models. This paper applies newly developed tests for nested models that are robust to the presence of parameter instability. The empirical evidence shows that for some countries we can reject the hypothesis that exchange rates are random walks. This raises the possibility that economic models were previously rejected not because the fundamentals are completely unrelated to exchange rate fluctuations, but because the relationship is unstable over time and, thus, difficult to capture by Granger causality tests or by forecast comparisons. We also analyze forecasts that exploit the time variation in the parameters and find that, in some cases, they can improve over the random walk.

Keywords

ForecastingExchange RatesParameter InstabilityRandom Walks
Type
ARTICLES
Information
Macroeconomic Dynamics , Volume 10 , Issue 1 , February 2006 , pp. 20 - 38
Copyright
© 2006 Cambridge University Press

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