DP3024 Why is it so Difficult to Beat the Random Walk Forecast of Exchange Rates?

Author(s): Lutz Kilian , Mark P Taylor

Publication Date: October 2001

Keyword(s): purchasing power parity , real exchange rate , random walk , economic models of exchange rate determination , long-horizon regression tests

JEL(s): C53 , F31 , F47

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP3024.asp

We propose an exchange rate model that can explain both the observed volatility and the persistence of real and nominal exchange rate movements and thus in some measure resolves Rogoff’s (1996) purchasing power parity puzzle. Our analysis reconciles the well-known difficulties in beating the random walk forecast model with the statistical evidence of nonlinear mean reversion in deviations from fundamentals. Our analysis also provides a compelling rationale for the long-horizon predictability of exchange rates. We find strong empirical support for long-horizon predictability, and we explain why it is difficult to exploit this predictability in real-time forecasts. Our results not only lend support to economists’ beliefs that the exchange rate is inherently predictable, but they also help us to understand the reluctance of applied forecasters to abandon chartist methods in favor of models based on economic fundamentals.