TY - JOUR AU - Engel, Charles AU - Mark, Nelson C AU - West, Kenneth D TI - Exchange Rate Models Are Not as Bad as You Think JF - National Bureau of Economic Research Working Paper Series VL - No. 13318 PY - 2007 Y2 - August 2007 DO - 10.3386/w13318 UR - http://www.nber.org/papers/w13318 L1 - http://www.nber.org/papers/w13318.pdf N1 - Author contact info: Charles Engel Department of Economics University of Wisconsin 1180 Observatory Drive Madison, WI 53706-1393 Tel: 608/262-3697 Fax: 608/262-2033 E-Mail: cengel@ssc.wisc.edu Nelson Mark Department of Economics 3060 Jenkins-Nanovic Hall University of Notre Dame Notre Dame, IN 46556 Tel: 574/631-0518 Fax: 574/631-4783 E-Mail: nmark@nd.edu Kenneth D. West Department of Economics University of Wisconsin 1180 Observatory Drive Madison, WI 53706 Tel: 608/262-0033 Fax: 608/262-2033 E-Mail: kdwest@wisc.edu M1 - published as Charles Engel, Nelson C. Mark, Kenneth D. West. "Exchange Rate Models Are Not As Bad As You Think," in Daron Acemoglu, Kenneth Rogoff and Michael Woodford, editors, "NBER Macroeconomics Annual 2007, Volume 22" University of Chicago Press (2008) AB - Standard models of exchange rates, based on macroeconomic variables such as prices, interest rates, output, etc., are thought by many researchers to have failed empirically. We present evidence to the contrary. First, we emphasize the point that "beating a random walk" in forecasting is too strong a criterion for accepting an exchange rate model. Typically models should have low forecasting power of this type. We then propose a number of alternative ways to evaluate models. We examine in-sample fit, but emphasize the importance of the monetary policy rule, and its effects on expectations, in determining exchange rates. Next we present evidence that exchange rates incorporate news about future macroeconomic fundamentals, as the models imply. We demonstrate that the models might well be able to account for observed exchange-rate volatility. We discuss studies that examine the response of exchange rates to announcements of economic data. Then we present estimates of exchange-rate models in which expected present values of fundamentals are calculated from survey forecasts. Finally, we show that out-of-sample forecasting power of models can be increased by focusing on panel estimation and long-horizon forecasts. ER -