Exchange Rate Determination : Single-Equation or Economy-Wide Models? A Test Against the Random Walk

We first give a brief presentation of the existing single-equation structural models of exchange-rate determination and a survey of how the exchange rate is modeled in the main economy-wide macroeconometric models. We then show, with respect to the lira/$ exchange rate, that the out-of-sample predictive performance of the single-equation models is inferior to that of the simple random walk model. This confirms the thesis that only by moving away from these single-equation, semi-reduced form models towards suitable economy-wide macroeconometric models can one hope to beat the random walk. Following this course, we finally show that the Mark V version of our continuous time macroeconometric model of the Italian economy outperforms both the existing structural models and the random-walk process, in out-of-sample forecasting tests concerning the lira/$ exchange rate