Determinants of the exchange rate in Colombia under inflation targeting

Abstract

This research studies the forecasting performance of conventional and more recent exchange rate models in Colombia. The purpose is to explain which have been the main exchange rate determinants under an Inflation Targeting regime and a completely floating exchange rate scheme. Compared to similar studies, this paper includes conventional specifications and Taylor rule approaches that assume exogenous and endogenous monetary policy respectively. Based on the Johansen multivariate cointegration methodology, the results provide evidence for the existence of cointegration in all specifications except in the Sticky-Price Monetary Model and the Taylor Rule model that includes the real exchange rate. In addition, out of sample forecasting performance is analyzed in order to compare if all specifications outperform the drift less random walk model. All models outperform the random walk at one month horizon. However, the Flexible Price Monetary Model and the Uncovered Interest Parity Condition have superior predictive power for longer horizons.