Modeling and Predicting the EUR/USD Exchange Rate: The Role of Nonlinear Adjustments to Purchasing Power Parity

Reliable medium-term forecasts are essential for forward-looking monetary policy decisionmaking. Traditionally, predictions of the exchange rate tend to be linked to the equilibrium concept implied by the purchasing power parity (PPP) theory. In particular, the traditional benchmark for exchange rate models is based on a linear adjustment of the exchange rate to the level implied by PPP. In the presence of aggregation effects, transaction costs or uncertainty, however, economic theory predicts that the dynamics of the nominal exchange rate around the equilibrium value implied by PPP are nonlinear. This paper presents some of the shortcomings of the traditional linear exchange rate models and assesses whether alternative nonlinear formulations outperform them for forecasting purposes. We find that the theory of nonlinear adjustment to PPP is supported by the data in a threshold cointegration framework for the monthly EUR/USD exchange rate between 1990 and 2010. Furthermore, sizeable gains in terms of medium-term forecast accuracy can be obtained using nonlinear specifications.