Can Taylor rule fundamentals predict exchange rates?

Wan, Yiding (2012) Can Taylor rule fundamentals predict exchange rates? Doctoral thesis, University of East Anglia.

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    Recent research suggests that there are many favourable features of the asset-
    pricing model of exchange rates incorporating Taylor rules. Against this back-
    ground, this thesis focuses on the relationship between the exchange rate and
    Taylor rule fundamentals. The introductory chapter provides a short summary
    of the most relevant literature, and explains the connections between the main
    chapters. In chapter 2, we mainly follow Engel and West's (2006) framework of
    the asset-pricing model of exchange rate incorporating Taylor rules to forecast
    the yen/dollar exchange rate. The central research question is whether this type
    of model has any predictive power with respect to the exchange rate.
    In chapter 3, a more detailed analysis of the properties of Taylor rules is un-
    dertaken. The main idea derives from one of the assumptions made in chapter 2,
    concerning the structural stability of the Taylor rules. If there are unknown struc-
    tural breaks, the estimation of the Taylor rule is likely to be biased. Furthermore,
    both theoretical and empirical studies suggest that the Taylor rule in advanced
    economies is asymmetric. If a central bank is minimizing an asymmetric loss
    function in which negative and positive in
    ation- and output-gap deviation are,
    respectively, assigned di�erent weights, then a nonlinear Taylor rule is optimal.
    Hence we set out to identify any structural breaks in the Taylor rule, and to
    uncover the extent to which nonlinearity plays a role in Taylor rule modelling. In
    our empirical study, a threshold model introduced by Caner and Hansen (2004) is
    used to measure whether the Taylor rules are nonlinear or not, in order to explain
    the existence of asymmetry of Taylor rules.
    Chapter 4 compares the performance of the traditional monetary model and
    the Taylor rule model in terms of out-of-sample forecasting performance. A key
    study is by Molodtsova and Papell (2009) who derive a simple version of the
    Taylor rule model and demonstrate that it can outperform a variety of monetary
    models as well as the naive random walk, on the basis of the state-of-the-art
    goodness-of-�t statistic developed by Clark and West (2006) (the CW statistic).
    It is of considerable interest to discover whether Molodtsova and Papell's (2009)
    results are driven by the superior predictability of the Taylor rule fundamentals,
    or by features of the CW statistic. To address this question, the sterling/dollar
    exchange rate for the period 1975-2010 is investigated. A detailed analysis of
    the CW statistic, including Monte-Carlo simulations, is conducted. In addition,
    a variety of estimators are used, including the Vector Error Correction Method
    (VECM) which is used to generate the out-of-sample forecast. Also, a number
    of goodness-of-�t measures (in addition to CW) are used for comparing the pre-
    dictability of the Taylor rule model with traditional monetary models. The overall
    �nding is that the out-of-sample forecasting predictability of the sterling/dollar
    exchange rate obtained by the Taylor rule model is not as signi�cant as we ex-
    pect by using a variety of goodness-of-�t measures, but the traditional monetary
    models have certain predictive power if VECM is applied.

    Item Type: Thesis (Doctoral)
    Faculty \ School: Faculty of Social Sciences > School of Economics
    Depositing User: Mia Reeves
    Date Deposited: 08 May 2013 12:45
    Last Modified: 08 May 2013 12:45

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