Stochastic Movements in the Underlying Parameters

Abstract

Incorporating stochastic movements into the parameters of exchange rate models (by estimating the models in a time-varying parametric framework) leads to an improvement in forecasting accuracy in terms of the magnitude of error. Although Meese and Rogoff are correct in suggesting that the use of TVP enhances forecasting accuracy, the improvement is insufficient to outperform the random walk in terms of the magnitude of the error. However, the random walk is outperformed by exchange rate models estimated in a TVP framework when forecasting accuracy is assessed by alternative metrics. The Meese-Rogoff puzzle can be resolved using alternative measures of forecasting accuracy, but not by the mere use of TVP estimation while the RMSE is used as a criterion.