How many fundamentals should we include in the behavioral equilibrium exchange rate model?

Abstract

This paper evaluates the reliability of alternative equilibrium exchange rate assessments. The literature has predominantly relied on the behavioral equilibrium exchange rate (BEER) model, which attempts to establish a long-term link between the real exchange rate and economic fundamentals. We challenge the recent tendency among BEER modelers to increase the number of regressors. The wisdom of this choice is evaluated with the criterion that equilibrium exchange rates should help predict the future trajectory of real exchange rates. Using panel data for 30 countries during the period 1991–2018, we show that it is hard to outperform both a parsimonious BEER model (with only three fundamentals) and the relative PPP model (which excludes a role for fundamentals in the long run). This finding calls for caution in the ability of economists to closely map the evolution of equilibrium exchange rates and economic fundamentals. • Behavioral equilibrium exchange rate (EER) models are widely used by policy makers. • Large BEER models are commonly believed to be more reliable than simple ones. • We assess BEER model reliability within a forecasting competition framework. • We find that the increased model complexity is counterproductive out-of-sample. • The claim that we understand long-term drivers of real exchange rates beyond PPP is doubtful.