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Revisiting the Dollar-Euro Permanent Equilibrium Exchange Rate: Evidence from Multivariate Unobserved Components Models

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  • Chen, Xiaoshan
  • MacDonald, Ronald

Abstract

We propose an alternative approach to obtaining a permanent equilibrium exchange rate (PEER), based on an unobserved components (UC) model. This approach offers a number of advantages over the conventional cointegration-based PEER. Firstly, we do not rely on the prerequisite that cointegration has to be found between the real exchange rate and macroeconomic fundamentals to obtain non-spurious long-run relationships and the PEER. Secondly, the impact that the permanent and transitory components of the macroeconomic fundamentals have on the real exchange rate can be modelled separately in the UC model. This is important for variables where the long and short-run effects may drive the real exchange rate in opposite directions, such as the relative government expenditure ratio. We also demonstrate that our proposed exchange rate models have good out-of sample forecasting properties. Our approach would be a useful technique for central banks to estimate the equilibrium exchange rate and to forecast the long-run movements of the exchange rate.

Suggested Citation

  • Chen, Xiaoshan & MacDonald, Ronald, 2010. "Revisiting the Dollar-Euro Permanent Equilibrium Exchange Rate: Evidence from Multivariate Unobserved Components Models," SIRE Discussion Papers 2010-41, Scottish Institute for Research in Economics (SIRE).
    • Handle: RePEc:edn:sirdps:173
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    2. Imre Vámos & Zsuzsanna Novák, 2015. "Four currencies outside the eurozone," International Journal of Business and Economic Sciences Applied Research (IJBESAR), Democritus University of Thrace (DUTH), Kavala Campus, Greece, vol. 8(3), pages 97-108, December.

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    More about this item

    Keywords

    Permanent Equilibrium Exchange Rate; Unobserved Components Model; Exchange rate forecasting;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F47 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Forecasting and Simulation: Models and Applications

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