The equilibrium level and forecasting performance of nominal effective exchange rate indexes using an export and import price-based relative PPP model

Abstract

While the majority of studies on purchasing power parity (PPP) and exchange rate forecasting focus on bilateral exchange rates, the purpose of this article is to analyse the aggregate nominal effective exchange rate index of six major currencies. Export and import price indexes are used to construct relative PPP-based equilibrium exchange rates. Applying an alternative approach based on the exchange rate deviations from equilibrium, we find half-lives of less than 1 year in some cases. Additionally, we report success rates of correctly predicting the direction of the exchange rate indexes as high as 70%. The success rates improve for longer horizons and when the investigation is restricted to large deviations from PPP-equilibrium. Finally, and most importantly, for the period following the start of the global financial crisis (2007 to 2012), the model outperforms the random walk for four of the six exchange rate indexes. The findings provide important implications for international market participants who are interested in a general guide about a currencies aggregate equilibrium level as well its future movements.