A New Approach to Forecasting Exchange Rates

Kenneth Clements and Yihui Lan (ylan@biz.uwa.edu.au)
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Yihui Lan: UWA Business School, The University of Western Australia

No 06-29, Economics Discussion / Working Papers from The University of Western Australia, Department of Economics

Abstract: Building on purchasing power parity theory, this paper proposes a new approach to forecasting exchange rates using the Big Mac data from The Economist magazine. Our approach is attractive in three aspects. Firstly, it uses easily-available Big Mac prices as input. These prices avoid several serious problems associated with broad price indexes, such as the CPI, that are used in conventional PPP studies. Secondly, this approach provides real-time exchange-rate forecasts at any forecast horizon. Such real-time forecasts can be made on a day-to-day basis if required, so that the forecasts are based on the most up-to-date information set. These high-frequency forecasts could be particularly appealing to decision makers who want up-to-date forecasts of exchange rates. Finally, as our forecasts are obtained through Monte Carlo simulation, estimation uncertainty is made explicit in our framework which provides the entire distribution of exchange rates, not just a single point estimate. A comparison of our forecasts with the random walk model shows that although the random walk is superior for very short horizons, our approach tends to dominate over the medium to longer term.

Keywords: Exchange-rate forecasting; Bic Mac prices; purchasing power parity; Monte Carlo simulation (search for similar items in EconPapers)
JEL-codes: C53 F30 (search for similar items in EconPapers)
Pages: 24 pages
Date: 2006
New Economics Papers: this item is included in nep-cba, nep-for and nep-ifn
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Journal Article: A new approach to forecasting exchange rates (2010)
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