Taylor rules and exchange rate predictability in emerging economies

Abstract

This study demonstrates the relationship between exchange rate determination and an endogenous monetary policy represented by Taylor rules. We fill a gap in the literature by focusing on a group of fifteen emerging economies that adopted free-floating exchange rates and inflation targeting beginning in the mid-1990s. Because of the limited span of the time series, which is a common obstacle to studying emerging economies, we employ panel data regressions to produce more efficient estimates. Following the recent literature, we use a robust set of out-of-sample statistics, incorporating bootstrapped and asymptotic distributions for the Diebold-Mariano statistic, the Clark and West statistic and Theil's U ratio. By evaluating different specifications for the Taylor rule exchange rate model based on their out-of-sample performances, we find that a present-value forward-looking specification shows strong evidence of exchange rate predictability.