IMF Working Papers

Medium-Term Exchange Rate Forecasting: What Can We Expect?

Author/Editor:

Guy M Meredith

Publication Date:

January 1, 2003

Electronic Access:

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Summary:

The medium-term predictability of exchange rate movements is examined using three models of fundamentals: purchasing power parity, the monetary model, and uncovered interest parity. While the first two approaches yield favorable in-sample results, these largely reflect finite-sample estimation biases. Adjusting for these biases, there is little evidence of predictability, consistent with the lack of systematic improvement in out-of-sample forecasting performance relative to a random walk. Uncovered interest parity fares better at long horizons, but reflects information already embodied in market prices; in this sense, it may not be useful as an indicator of exchange rate misalignment. While more elaborate models of fundamentals might have better medium-term forecasting properties, careful attention must be paid to finite-sample biases in assessing predictability.

Series:

Working Paper No. 2003/021

Subject:

Exchange rate adjustments Exchange rates Financial services Foreign exchange Interest rate parity Purchasing power parity Real effective exchange rates