Forecasting the Real Exchange Rates Behavior: An Investigation of Nonlinear Competing Models

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Prodan, Ruxandra; Liu, Yu
Forecast; Real exchange rates; Nonlinear models; Economics
article description
A large amount of literature finds that real exchange rates appear to be characterized by several non-linear specifications. While each of these nonlinear models fits some particular real exchange rates especially well, leading to good in-sample properties, the recent studies have not come to any consensus whether the nonlinear models could provide a better specification than the linear model and/or the random walk model according to their out-of-sample forecasting performances. Our goal is to examine two important nonlinear models (Band-TAR and ESTAR) concerning their abilities to generate out-of-sample forecasts, when estimating real exchange rates for 20 OECD countries. We find strong evidence that the ESTAR model, but not the linear or the Band-TAR model, outperforms the random walk model when forecasting out-of-sample. On the other hand, a comparison between the nonlinear models and the linear model is inconclusive due to the low power of tests for predictive ability when bootstrapping critical values.