Michele Ca' Zorzi, Marcin Kolasa, Michał Rubaszek, 03 March 2017

Macroeconomic models have been criticised for their inability to forecast exchange rates better than the random walk model. This column argues that open-economy DGSE models are useful in forecasting the real exchange rate but not the nominal exchange rate, owing to their failure to capture adequately the international co-movement of prices. They correctly predict, however, that the bulk of the real exchange rate adjustment occurs through the nominal rate. The central role of the nominal rate in restoring price competitiveness in flexible exchange rate regimes can be exploited from a forecasting perspective. 

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