The Reliability of Equilibrium Exchange Rate Models: A Forecasting Perspective

Michele Ca' Zorzi, Adam Cap, Andrej Mijakovic and Michał Rubaszek
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Adam Cap: Bank for International Settlements

International Journal of Central Banking, 2022, vol. 18, issue 3, 229-280

Abstract: In this paper we evaluate the predictive power of the three most popular equilibrium exchange rate concepts: purchasing power parity (PPP), behavioral equilibrium exchange rate (BEER), and the macroeconomic balance (MB) approach. We show that there is a trade-off between storytelling and forecast accuracy. The PPP model offers little economic insight, but has good predictive power. The BEER framework, which links exchange rates to fundamentals, does not deliver forecasts of better quality than PPP. The MB approach has the richest economic interpretation, but performs poorly in forecasting terms. Sensitivity analysis confirms that changing the composition of fundamentals in the BEER model or modifying key underlying assumptions in the MB model does not generally enhance their predictive power.

JEL-codes: C33 F31 F37 F41 (search for similar items in EconPapers)
Date: 2022
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