Error correction modelling and dynamic specifications as a conduit to outperforming the random walk in exchange rate forecasting

The proposition that dynamic exchange rate models can outperform the random walk in out-of-sample forecasting, in the sense that they produce lower mean square errors, is examined and disputed. By using several dynamic versions of three macroeconomic exchange rate models, it is demonstrated that dynamic specifications outperform the corresponding static models but improvement in the forecasting power may not be sufficient for the dynamic models to perform better than the random walk. The results are explained by suggesting that any dynamic specification or transformation of the static model leads to the introduction of a lagged dependent variable, which in effect is a random walk component. The analysis leads to the conclusion that it is implausible to aim at beating the random walk by augmenting a static model with a random walk component.     

Economic policy and prospects

Though now into their second term of office, the Government are still trying to fulfil the objectives of the first ‐ to cut public spending and reduce taxes. The hard choices they eventually make will in part be dictated by the following sorts of considerations:

• technical ‐ year‐to‐year forecasts

• economic ‐ growth in gdp

• political ‐ reduction in income support.

At the centre of these and other often conflicting sets of considerations is the Chancellor of the Exchequer. Chancellors make many statements, but few are as clear as that made by Nigel Lawson, in the course of an interview with Max Wilkinson, economics editor of the Financial Times, from which we have extracted the following.