Exchange Rate Determination and Out of Sample Forecasting: Cointegration Analysis

Forecasting the nominal exchange rate has been one of the most difficult exercises in economics. This study employs the Frankel (1979) monetary model of exchange rate to examine the long run behavior of Pakistan rupee per unit of US dollar over the period 1982:Q1 to 2012:Q2. Johansen and Juselious (1988,1992) likelihood ratio test indicates one long-run cointegrating vector among the fundamentals. Cointegrating vector is uniquely identified as Dornbusch (1976) monetary model by imposing plausible economic restrictions. Finally, the short-run dynamic error correction model is estimated on the bases of identified cointegrated vector. Out of sample forecasting analysis of parsimonious short run dynamic error correction model is able to beat the naïve random walk model on the basis of root mean square error, Theil’s U coefficient and Diebold and Mariano (1995) test statistics.