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Exchange Rate Models are Better than You Think, and Why They Didn't Work in the Old Days

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  • Engel, Charles
  • Wu, Steve Pak Yeung

Abstract

Exchange-rate models fit very well for the U.S. dollar in the 21st century. A “standard†model that includes real interest rates and a measure of expected inflation for the U.S. and the foreign country, the U.S. comprehensive trade balance, and measures of global risk and liquidity demand is well-supported in the data for the U.S. against other G10 currencies. The monetary and non-monetary variables play equally important roles in explaining exchange rate movements. In the 1970s – early 1990s, the fit of the model was poor but the fit (as measured by t- and F-statistics, and R2s) has increased almost monotonically to the present day. We make the case that it is better monetary policy (inflation targeting) that has led to the improvement, as the scope for self-fulfilling expectations has disappeared. We provide a variety of evidence that links changes in monetary policy to the performance of the exchange-rate model.

Suggested Citation

  • Engel, Charles & Wu, Steve Pak Yeung, 2024. "Exchange Rate Models are Better than You Think, and Why They Didn't Work in the Old Days," CEPR Discussion Papers 19328, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:19328
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    Cited by:

    1. Cormun, Vito & Ristolainen, Kim, 2024. "Exchange rate narratives," Bank of Finland Research Discussion Papers 11/2024, Bank of Finland.
    2. Vito Cormun & Kim Ristolainen, 2024. "Exchange Rate Narratives," Discussion Papers 167, Aboa Centre for Economics.

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    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange

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