A consumption-based approach to exchange rate predictability

We study whether the implications of an international consumption-based asset-pricing model are useful to provide out-sample predictability evidence for the real exchange rate. This model implies a predictability equation that results from the presence of both internal and external consumption habits in the utility function. In this equation, domestic, U.S. and world consumption growth are predictors of the real exchange rate. Our empirical exercises confirm this connection by providing evidence of short-term predictability on the bilateral rates of 15 out of 17 countries vis-à-vis the U.S. over the post Bretton-Woods float. A non-linear GMM estimation of some parameters of the model also brings about evidence of the presence of consumption habits in the utility function.