A generalized uncovered interest parity model of real exchange rates

Sticky price monetary models of the real exchange rate, while reasonable theoretically, have been disappointing empirically. The most likely reason is that shocks to the market's expectation of the future equilibrium real exchange rate weaken the stability of the statistical association between the real exchange rate and the real interest rate differential. This study identifies three types of shocks that appear to be important. These are productivity growth that changes the relative price of traded goods at home versus abroad, government budget deficits, and the real price of oil. ; These factors along with real interest rates are shown to explain about 80 percent of the longer run variation in both the real trade-weighted dollar and real bilateral rates against the dollar. However, taking these additional factors into account reduces the estimated effects of interest rates on the dollar. An error-correction model that includes these factors explains about half of the in-sample variation of changes in the real trade-weighted dollar and has out-of-sample prediction errors that are 60 percent lower than those from a naive model of no change at a horizon of eight quarters. ; Although the error-correction model explains nearly as much of the in-sample variation of changes in real bilateral rates as changes in the real trade-weighted dollar, its out-of-sample predictions of bilateral rates are not nearly as good. Nevertheless, they are distinctly better than those from a naive model of no change. This is an improvement over results from the simple open interest parity model that relies only on interest rates.