Model instability in predictive exchange rate regressions |
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Authors: | Niko Hauzenberger Florian Huber |
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Affiliation: | 1. Department of Economics, WU Vienna University of Economics and Business, Vienna, Austria;2. Salzburg Centre of European Union Studies (SCEUS), Paris Lodron University of Salzburg, Salzburg, Austria |
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Abstract: | In this paper we aim to improve existing empirical exchange rate models by accounting for uncertainty with respect to the underlying structural representation. Within a flexible Bayesian framework, our modeling approach assumes that different regimes are characterized by commonly used structural exchange rate models, with transitions across regimes being driven by a Markov process. We assume a time-varying transition probability matrix with transition probabilities depending on a measure of the monetary policy stance of the central bank at home and in the USA. We apply this model to a set of eight exchange rates against the US dollar. In a forecasting exercise, we show that model evidence varies over time, and a model approach that takes this empirical evidence seriously yields more accurate density forecasts for most currency pairs considered. |
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Keywords: | empirical exchange rate models exchange rate fundamentals Markov switching |
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