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Pablo Anaya Longaric

11 November 2021
Economic Bulletin Issue 7, 2021
This article reviews three popular equilibrium exchange rate models, the purchasing power parity (PPP), behavioural equilibrium exchange rate (BEER) and macroeconomic balance (MB) models. The aim is to address two questions: whether such models help in forecasting real and nominal exchange rates and which macroeconomic fundamentals contain such predictive power. The evidence suggests that real exchange rates adjust over time to their estimated real exchange rate equilibria only in the cases of the PPP and BEER models. Exploring this empirical regularity, it is possible to draw three important lessons. The first is that such equilibrium adjustment helps to forecast real exchange rates. The second lesson is that this real equilibrium adjustment process helps in forecasting nominal exchange rates, as most of the adjustment toward equilibrium is achieved by currency movements and not by relative price changes. The third is that most of the forecasting power comes from the exploitation of the mean-reverting properties of real exchange rates rather than an understanding of the relationship between exchange rates and economic fundamentals.
JEL Code
C33 : Mathematical and Quantitative Methods→Multiple or Simultaneous Equation Models, Multiple Variables→Panel Data Models, Spatio-temporal Models
F31 : International Economics→International Finance→Foreign Exchange
F37 : International Economics→International Finance→International Finance Forecasting and Simulation: Models and Applications
F41 : International Economics→Macroeconomic Aspects of International Trade and Finance→Open Economy Macroeconomics