COWLES FOUNDATION FOR RESEARCH IN
ECONOMICS Box 208281
COWLES FOUNDATION DISCUSSION PAPER NO. 1635 Estimating Exchange Rate Equations Using Estimated Expectations Ray C. Fair January 2008 This paper takes a somewhat different approach from the recent literature in estimating
exchange rate equations. It assumes uncovered interest rate parity and models how
expectations are formed. Agents are assumed to base their expectations of future interest
rates and prices, which are needed in the determination of the exchange rate, on
predictions from a ten equation VAR model. The overall model is estimated by FIML under
model consistent expectations. The model generally does better than the random walk model,
and its properties are consistent with observed effects on exchange rates from surprise
interest rate and price announcements. Also, the focus on expectations is consistent with
the large observed short run variability of exchange rates. |
