Ruhr Economic Papers

Ruhr Economic Papers #704

Forecasting Exchange Rates: The Time-Varying Relationship between Exchange Rates and Taylor Rule Fundamentals

by Ulrich Haskamp

RGS, UDE, 07/2017, 33 S./p., 8 Euro, ISBN 978-3-86788-818-9 DOI: 10.4419/86788818

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Abstract

There is empirical evidence for a time-varying relationship between exchange rates and
fundamentals. Such a relationship with time-varying coefficients can be estimated by
a Kalman filter model. A Kalman filter estimates the coefficients recursively depending
on the prediction error of the examined model. Using a Taylor rule based exchange
rate model, which in the literature was found to have promising forecasting abilities,
it is possible to further improve the performance if the utilization of information from
the prediction error is restricted. This is necessary as classic exchange rate models
do not perform badly solely because they neglect the time-varying relationship, but
also due to missing explanatory information. So, if the Kalman filter uses the entire
information from the prediction error, it would overestimate the need for coefficient
adjustment. With this calibration of the Kalman filter model the short-term out-ofsample
forecasting accuracy can be enhanced for 10 out of 12 exchange rates.

JEL-Classification: C53, F31, F37

Keywords: Exchange rates; forecasting; Kalman filter; state space models

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