Out-of-sample exchange rate predictability with Taylor rule fundamentals

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.jinteco.2008.11.001 Byline: Tanya Molodtsova (a), David H. Papell (b) Keywords: Out-of-sample predictability; Exchange rates; Taylor rules Abstract: An extensive literature that studied the performance of empirical exchange rate models following Meese and Rogoff's [Meese, R.A., Rogoff, K., 1983a. Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample? Journal of International Economics 14, 3-24.] seminal paper has not convincingly found evidence of out-of-sample exchange rate predictability. This paper extends the conventional set of models of exchange rate determination by investigating predictability of models that incorporate Taylor rule fundamentals. We find evidence of short-term predictability for 11 out of 12 currencies vis-a-vis the U.S. dollar over the post-Bretton Woods float, with the strongest evidence coming from specifications that incorporate heterogeneous coefficients and interest rate smoothing. The evidence of predictability is much stronger with Taylor rule models than with conventional interest rate, purchasing power parity, or monetary models. Author Affiliation: (a) Emory University, Department of Economics, Atlanta, GA 30322-2240, United States (b) University of Houston, Department of Economics, Houston, TX 77204-5882, United States Article History: Received 26 January 2007; Revised 20 November 2008; Accepted 24 November 2008