Model instability in predictive exchange rate regressions

Abstract

In this paper we aim to improve existing empirical exchange rate models by accounting for uncertainty with respect to the underlying structural representation. Within a flexible Bayesian framework, our modeling approach assumes that different regimes are characterized by commonly used structural exchange rate models, with transitions across regimes being driven by a Markov process. We assume a time-varying transition probability matrix with transition probabilities depending on a measure of the monetary policy stance of the central bank at home and in the USA. We apply this model to a set of eight exchange rates against the US dollar. In a forecasting exercise, we show that model evidence varies over time, and a model approach that takes this empirical evidence seriously yields more accurate density forecasts for most currency pairs considered.