Taylor Rules and Exchange Rate Predictability in Emerging Economies

Abstract

This study links exchange rate determination and 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 rate and inflation targeting beginning in the mid-1990s. Due to the limited time-series span, 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 using bootstrapped and asymptotic distributions for the Diebold-Mariano, Clark and West and Theil’s U ratio. By evaluating different specifications for the Taylor rule exchange rate model based on their out-of-sample performance, we find that the forward-looking specification shows strong evidence of exchange rate predictability.