22

The Econometrics of Exchange Rates

Efthymios G. Pavlidis, Ivan Paya and David A. Peel

Abstract

We provide a selective overview of the econometric methods employed in modeling some of
the key relationships which determine the behavior of exchange rates and the efficacy of models
employed to forecast them.

22.1 Introduction 1026
22.2 Real exchange rates 1027
22.2.1 Smooth transition (STR) models 1028
22.2.1.1 Linearity testing against STR 1029
22.2.1.2 Nonlinear STR estimation 1032
22.2.1.3 Time-varying equilibrium real exchange rate 1033
22.2.2 Threshold autoregressive (TAR) models 1035
22.2.2.1 Unit root test versus TAR 1036
22.3 International parity conditions 1037
22.3.1 Covered interest parity (CIP) 1037
22.3.2 Uncovered interest parity (UIP) 1040
22.4 Target zone models 1046
22.4.1 Method of simulated moments (MSM) 1047
22.4.2 Smooth transition autoregressive target zone 1049
22.5 Speculative bubbles 1050
22.5.1 Theory 1050
22.5.2 Testing and evidence 1052
22.6 Exchange rates, economic fundamentals and forecasting 1053
22.6.1 Long-horizon regressions 1054
22.6.1.1 Turning on the microscope 1056
22.6.1.2 Forecast evaluation measures 1058
22.6.2 Nonlinear models 1060
22.6.3 Real-time forecasting and market expectations 1061
22.6.4 Panels 1064
22.7 Conclusions 1065

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