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The Reliability of Equilibrium Exchange Rate Models: A Forecasting Perspective

Author

Listed:
  • Michele Ca' Zorzi

    (European Central Bank)

  • Adam Cap

    (Bank for International Settlements)

  • Andrej Mijakovic

    (European University Institute)

  • Michal Rubaszek

    (SGH Warsaw School of Economics)

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.

Suggested Citation

  • Michele Ca' Zorzi & Adam Cap & Andrej Mijakovic & Michal Rubaszek, 2022. "The Reliability of Equilibrium Exchange Rate Models: A Forecasting Perspective," International Journal of Central Banking, International Journal of Central Banking, vol. 18(3), pages 229-280, September.
    • Handle: RePEc:ijc:ijcjou:y:2022:q:3:a:6
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    More about this item

    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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