The U.S. Economic Downturn And The Euro-Dollar Exchange Rates

Abstract

In this article, we test the forecasting performance of empirical exchange rate models to assess in-and out-of-sample fits. The recent U.S. economic downturn has induced the Federal Reserve to decrease the federal fund rate (FFR) regularly, which has further weakened the dollar against major currencies, particularly the euro. To overcome the economic recession, the European Central Bank has also followed this trend by lowering the Euribor. Therefore, the parity power of these two currencies is basically affected by the reaction of European Central Bank against the Federal Reserve. By using the generalized method of moments (GMM), we attempt to predict the behavior of the euro-dollar exchange rates according to various empirical models. Based on different criteria which includes the root mean squared error (RMSE), the mean absolute error (MAE), the Theil coefficient, and variance proportion, our results suggest that the interest rate parity model can predict the euro-dollar exchange rate more accurately than other structural models including a random walk, which alters the results of Meese and Rogoff’s work.