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How many fundamentals should we include in the behavioral equilibrium exchange rate model?

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  • Ca’ Zorzi, Michele
  • Rubaszek, Michał

Abstract

This paper evaluates the reliability of alternative equilibrium exchange rate assessments. The literature has predominantly relied on the behavioral equilibrium exchange rate (BEER) model, which attempts to establish a long-term link between the real exchange rate and economic fundamentals. We challenge the recent tendency among BEER modelers to increase the number of regressors. The wisdom of this choice is evaluated with the criterion that equilibrium exchange rates should help predict the future trajectory of real exchange rates. Using panel data for 30 countries during the period 1991–2018, we show that it is hard to outperform both a parsimonious BEER model (with only three fundamentals) and the relative PPP model (which excludes a role for fundamentals in the long run). This finding calls for caution in the ability of economists to closely map the evolution of equilibrium exchange rates and economic fundamentals.

Suggested Citation

  • Ca’ Zorzi, Michele & Rubaszek, Michał, 2023. "How many fundamentals should we include in the behavioral equilibrium exchange rate model?," Economic Modelling, Elsevier, vol. 118(C).
    • Handle: RePEc:eee:ecmode:v:118:y:2023:i:c:s026499932200308x
    DOI: 10.1016/j.econmod.2022.106071
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    More about this item

    Keywords

    Equilibrium exchange rate models; Forecasting; Panel data;
    All these keywords.

    JEL classification:

    • C33 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Models with Panel Data; Spatio-temporal Models
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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