Integration, Cointegration and the Forecast Consistency of Structural Exchange Rate Models

55 Pages Posted: 15 Sep 2000 Last revised: 29 Sep 2022

See all articles by Yin-Wong Cheung

Yin-Wong Cheung

University of California, Santa Cruz - Department of Economics

Menzie David Chinn

University of Wisconsin, Madison - Robert M. La Follette School of Public Affairs and Department of Economics; National Bureau of Economic Research (NBER)

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Date Written: February 1997

Abstract

Exchange rate forecasts are generated using some popular monetary models of exchange rates in conjunction with several estimation techniques. We propose an alternative set of criteria for evaluating forecast rationality which entails the following requirements: the forecast and the actual series i) have the same order of integration, ii) are cointegrated, and iii) have a cointegrating vector consistent with long run unitary elasticity of expectations. When these conditions hold, we consider the forecasts to be consistent.' We find that it is fairly easy for the generated forecasts to pass the first requirement. However, according to the Johansen procedure, cointegration fails to hold the farther out the forecasts extend. At the one year ahead horizon, most series and their respective forecasts do not appear cointegrated. Of the cointegrated pairs, the restriction of unitary elasticity of forecasts with respect to actual appears not to be rejected in general. The exception to this pattern is in the case of the error correction models in the longer subsample. Using the Horvath-Watson procedure, which imposes a unitary coefficient restriction, we find fewer instances of consistency, but a relatively higher proportion of the identified cases of consistency are found at the longer horizons.

Suggested Citation

Cheung, Yin-Wong and Chinn, Menzie David, Integration, Cointegration and the Forecast Consistency of Structural Exchange Rate Models (February 1997). NBER Working Paper No. w5943, Available at SSRN: https://ssrn.com/abstract=225724

Yin-Wong Cheung (Contact Author)

University of California, Santa Cruz - Department of Economics ( email )

Engineering 2, Department of Economics
University of California
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Menzie David Chinn

University of Wisconsin, Madison - Robert M. La Follette School of Public Affairs and Department of Economics ( email )

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