The Theory of Exchange Rate Determination, and Exchange Rate Forecasting

Abstract

The theory of exchange rate determination is in an unsatisfactory state. From the theoretical point of view the debates between the traditional flow approach and the modern asset-market approach have seen the victory of the latter. But from the empirical point of view the forecasting ability of the theoretical models remains very poor. The results of Meese and Rogoff (1983a, b) came as a shock to the profession. According to these studies, the current structural models of exchange-rate determination failed to outperform the random walk (RW) model in out-of-sample forecasting experiments even when the actual realised values of the explanatory variables were used (ex post forecasts). The results of Meese and Rogoff have been substantially confirmed in many subsequent papers, for example Alexander and Thomas (1987), but for a survey of the subsequent literature see Gandolfo, Padoan and Paladino (1990a, b).

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