Exchange rate prediction using monetary policy rules in Taiwan

Abstract

This study examines exchange rate predictability based on different types of monetary policy rules in Taiwan. The out-of-sample exchange rate predictive accuracy is compared based on the Taylor rule fundamentals to a naïve random walk model. We find that both short-horizon and long-horizon out-of-sample exchange rate predictive power outperform the random walk process in many cases. The stronger evidence relates to the Taylor rule models with interest rate smoothing. The strongest evidence comes from the specifications which involve higher-order interest rate smoothing in the trade-weighted Taiwan Dollar rate. The findings are confirmed by the contemporaneous Taylor rules, the homogeneous coefficients, and the examinations of the nonlinear least squares approaches.

Keywords:

• Exchange rate disconnect
• monetary policy rule
• out-of-sample prediction

Acknowledgements

The authors would like to thank Ulf von Kalckreuth Sirko Leonhardt, Chang-Ching Lin, Takashi Matsuki and Jyh-Lin Wu as well as seminar participants at the 2014 International Congress on Economy, Finance and Business for valuable comments with Che-Yi Su for excellent research assistance. The study was completed while the first author was visiting at the School of Economics, University of Nottingham, UK. The usual disclaimer applies.

Notes

No potential conflict of interest was reported by the authors.

Accepted by Yin-Wong Cheung.

1 The export-to-GDP ratio in Taiwan, for example, reached in 2008 (see, Chen and Wu 2010).

2 Singapore, for instance, formally pegs its currency against a basket of trade-weighted currencies, used as an intermediate target, to assure that the inflation target is attained (see Cavoli, Pontines, and Rajan 2012).

3 As for the expected inflation, we simply use the Hodrick and Prescott (1997) (HP) filter to rule out the potential cycle and trend of inflation. We adopt a smoothing parameter equal to 14, 400 to detrend the monthly inflation series using the HP filter and then obtain the expected inflation.

4 According to the Central Bank Act in Taiwan, there are four major goals of the Central Bank of Taiwan. They are: (1) to promote financial market stability; (2) to ensure sound banking operations; (3) to maintain the stability of the internal and external value of the currency; (4) to foster the economic development.

5 This assumption is usually used in exchange rate prediction based on monetary fundamentals for a small open economy case. Some recent studies, for example, Molodtsova and Papell (2009), consider both symmetric and asymmetric monetary policies between the domestic and foreign countrries.

6 In general, the partial adjustment setup can be non-smoothing, i.e. , the first order smoothing, i.e. , and the second order smoothing, i.e. . For more details, see Clarida, Galí, and Gertler (1998, 2000).

7 For more details of contemporaneous and forward-looking Taylor rules, please refer to Rudebusch (2002).

8 Similarly, the smoothing parameter is equal to 14, 400 in this study to detrend the monthly industrial production by using the HP filter.

9 For more details, see Schmitz et al. (2013). The authors are grateful to Ulf von Kalckreuth Sirko Leonhardt for the helpful information regarding the problem of Germany currencies. The specific Deutsche Mark rate is obtained from Global Insight, Inc.

10 However, the statistics for the output gaps measured by both the quadratic trend and the HP filter are available upon request from the author.

Additional information

Funding

This work supported by National Science Council of Taiwan [NSC 101-2410-H-259-016].