International Finance Table of Contents Summary 3 Appraisal 6 Reference 9 9 9 Summary Out-of-sample exchange rate forecasting when used with real-time data helps to determine the exchange rate of the country. Numerous economists used different models to determine the exchange rates which is not claimed to be appropriate due to the unavailability of real-time data which are available with the market participants…
Furthermore, the models have been estimated with Organization for Economic Co-operation and Development (OECD) estimates of the output gap in relation to the unemployment gap and use these two figures of the same period along with one-year-ahead forecasts for determining the inflation level in order to compare with the real economic activity. Thus, the article provides an assessment of four models with specified Taylor rule. Moreover, the performances of conventional monetary, Purchasing Power Parity (PPP), and interest rate differential model have been evaluated for comparing each of the four models (Molodtsova & Papell, 2010). Due to the unavailability of euro or dollar exchange rates till 1999 when the euro had been introduced, rolling regressions methods have been used to predict the exchange rate changing from the year 1999 along with 26 observations for each regression. However, the number of observations has been kept constant while deriving the results from the year ending 2007 with 37 predictions, all the way through to 2010, with 45 predictions. The results have further been represented through three test statistics, namely, ‘ratio of the mean squared prediction errors (MSPE) of the linear and random walk models, DMW test of Diebold and Marino (1995) along with West (1996) and the CW test of Clark and West (2006)’ with the significant values of McCracken (Molodtsova & Papell, 2010). The results derived from the Taylor rule fundamentals model reveal an attractive apparent pattern. It has been observed that along with the variables of that period and rising inflation, MSPE of the Taylor rule model is lesser compared to MSPE of the random walk model. Furthermore, utilizing the CW and DMW tests at 5% or higher level for the early predictions of year ended 2007, it has been noted that the random walk null can be discarded in favor of the Taylor rule model. Therefore, following the number of predictions increase, the strength of the rejections increased which hit the highest level in 2008. However, from the next quarter of 2008, the strength of the rejections started to decline and thus, climbed to the extreme level of financial crisis thereby, favoring the Taylor rule specifications sharply. In 2009, the ‘phoenix’ Taylor rule forecasting evolved which was discarded in favor of Taylor rule models at 1% implication level for all specifications between 2009 and 2010. Although the pattern of results has similarities with the inflation level in the beginning of 2008, the strength of the rejections is weaker. Furthermore, the results derived from forecasted variables are weaker than actual variables from that period (Molodtsova & Papell, 2010). Mark (1995) theories focused on obtaining a set of long-run fundamentals from the different models which helped in evaluating out-of-sample forecasts on the basis of the difference between the present exchange rate and its value in the long run. Another part of the theory uses the interest rate obscured by Taylor rule whereas, Molodtsova and Papell (2009) uses the variables that are utilized in Taylor rules to estimate the exchange rate predictions. Furthermore, the Taylor rule fundamentals model helps to evaluate the correlation between the exchange rate and a number of variables that ...
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