Measuring the Euro-Dollar Permanent Equilibrium Exchange Rate using the Unobserved Components Model

Citation

Chen X & MacDonald R (2014) Measuring the Euro-Dollar Permanent Equilibrium Exchange Rate using the Unobserved Components Model. Stirling Economics Discussion Paper, 2014-12.

Abstract
This paper employs an unobserved component model that incorporates a set of economic fundamentals to obtain the Euro-Dollar permanent equilibrium exchange rates (PEER) for the period 1975Q1 to 2008Q4. The results show that for most of the sample period, the Euro-Dollar exchange rate closely followed the values implied by the PEER. The only significant deviations from the PEER occurred in the years immediately before and after the introduction of the single European currency. The forecasting exercise shows that incorporating economic fundamentals provides a better long-run exchange rate forecasting performance than a random walk process.

Keywords
Permanent Equilibrium Exchange Rate; Unobserved Components Model; Exchange rate forecasting

JEL codes

• F31: Foreign Exchange
• F47: Macroeconomic Aspects of International Trade and Finance: Forecasting and Simulation: Models and Applications