# Exchange Rate Forecasting

**Topics:**Inflation, Exchange rate, Foreign exchange market

**Pages:**8 (2782 words)

**Published:**October 8, 2008

a.Purchasing Power Parity (PPP) Model

The PPP model explains the movements of the exchange rate between two economies’ currencies by the changes in the countries’ price levels. The goods-market arbitrage mechanism will move the exchange rate to equalise prices in the two economies (Madura 2006). Mathematically, the exchange rate determination under the PPP model is expressed as: lnet = lnpt – lnpt*

where et is the nominal exchange rate, pt and pt* are domestic and foreign prices respectively. The PPP model which is specified as a restrictive error-correction form, following that used in Cheung et al. (2004) is written as: lnet+h – lnet = αo + α1 (lnet - βo – β1lnp~t) + εt where p~t is the domestic price level relative to the foreign price level, εt is a zero mean error term, and h is the forecast horizon. The restrictive setup explicitly allows the variation of the exchange rate as a correction of its last-period deviation from a long-run equilibrium b.Uncover Interest Rate Parity (UIP) Model

The UIP describes how the exchange rate moves according to the expected returns of holding assets in two different currencies. Ignoring transaction cost and liquidity constraints, the UIP gives an arbitrage mechanism that drives the exchange rate to a value that equalises the returns on holding both the domestic and foreign assets (Madura 2006). Specifically, if the UIP holds, the arbitrage relationship will give the following expression: Et(lnet+h – lnet) = it – it*

where Et(lnet+h – lnet) is the market expectation of the exchange rate return from time t to time t+h; it and it* are the interest rate of the domestic and foreign currencies respectively (Cheung et al. 2004) The UIP model is also tested in the restrictive error-correction form, that is, lnet+h – lnet = αo + α1 (lnet - βo – β1lni~t) + εt where i~t is the domestic long-term interest rate relative to that in the foreign country. c.The Structural Models

There are three models selected by Meess and Rogoff (1983) as representatives for this category. They are flexible-price monetary (Frenkel-Bilson) model, the sticky-price monetary (Dornbusch-Frankel) model, and the sticky-price asset (Hooper-Morton) model. The general quasi-reduced form specifications of all three models are: lnet = ao + a1(lnmt – lnm*t) + a2(lnyt - lny*t) + a3(lnis - lni*s) + a4(lnπe-lnπe*) + a5TB + a6TB* + u where mt is the domestic money supply, yt is the domestic output, is is the short-term interest rate and πe is the expected long-run inflation. TB and TB* represent the cumulated U.S. and foreign trade balances, and u is a disturbance term.

The exchange rate exhibits first degree homogeneity in the relative money supplies, i.e a1 = 1 for all the models. The Frenkel-Bilson model, which assumes purchasing power parity, constraints a4 = a5 = a6 = 0. The Dornbusch-Frankel , which allows for slow domestic price adjustment and consequent deviations from PPP, set a5 = a6 = 0. The Hooper-Morton model which allows for changes in the long-run real exchange rate does not constrain any of the coefficients...

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