Quantitative and Qualitative Analysis in Social Sciences
Abstract
We examine the predictive power of real time linear monetary models with possible nonlinear adjustment in
forecast errors for the GBP/USD exchange rates. Real time revisions of UK and US monetary aggregates
and output are significant; therefore the use of final data on fundamentals in forecasting exchange rates may
yield misleading inferences. By studying recursive forecast errors we claim that in several instances, real
time fundamental equilibrium values of exchange rates may be determined in a linear fashion, whereas the
adjustment towards fundamentals driven equilibrium values may take a discrete or smooth nonlinear form.
Revisions in fundamentals, particularly in the US and UK monetary aggregates and real output, seem to
matter mainly for short term forecastability of exchange rates. We find short term forecastability in the form
of discrete nonlinear adjustment in some real time vintages. We also document long term forecastability in
the form of a smooth nonlinear adjustment towards fundamentals determined equilibrium values of exchange
rates