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Estimating Exchange Rate Equations Using Estimated Expectations

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Abstract

This paper takes a somewhat different approach from the recent literature in estimating exchange rate equations. It assumes uncovered interest rate parity and models how expectations are formed. Agents are assumed to base their expectations of future interest rates and prices, which are needed in the determination of the exchange rate, on predictions from a ten equation VAR model. The overall model is estimated by FIML under model consistent expectations. The model generally does better than the random walk model, and its properties are consistent with observed effects on exchange rates from surprise interest rate and price announcements. Also, the focus on expectations is consistent with the large observed short run variability of exchange rates.

Suggested Citation

  • Ray C. Fair, 2008. "Estimating Exchange Rate Equations Using Estimated Expectations," Cowles Foundation Discussion Papers 1635, Cowles Foundation for Research in Economics, Yale University.
    • Handle: RePEc:cwl:cwldpp:1635
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    File URL: https://cowles.yale.edu/sites/default/files/files/pub/d16/d1635.pdf
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    References listed on IDEAS

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    1. Philippe Bacchetta & Eric Van Wincoop, 2006. "Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?," American Economic Review, American Economic Association, vol. 96(3), pages 552-576, June.
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    Cited by:

    1. Merza, Ebrahim & Moosa, Imad A., 2023. "Pitfalls in Econometric Forecasting with Illustrations from Exchange Rate Economics," Economia Internazionale / International Economics, Camera di Commercio Industria Artigianato Agricoltura di Genova, vol. 76(2), pages 147-172.

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    More about this item

    Keywords

    Exchange rate equations; Uncovered interest rate parity;

    JEL classification:

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

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