Discussion of “Can Parameter Instability Explain the Meese-Rogoff Puzzle”, by Bacchetta, van Wincoop and Beutler

BWB investigate whether exchange rate unpredictability is due to instabilities of the relationship between exchange rates and its fundamentals. In their exercise, BWB calibrate on actual data a model where the parameters linking exchange rates and fundamentals are allowed to change over time. BWB find that the pattern of out-of-sample (un)predictability assessed on data generated from a fixed coefficient model can roughly reproduce the features observed in the data. In addition, BWB find no significant differences in out-of-sample accuracy when data are generated by time varying rather than fixed coefficients. Significant impact of parameter instability is found only when shift in parameters are persistent but in this case parameters instability increases rather than reducing predictability. On the basis of these findings the authors conclude that exchange rate unpredictability is due to the weakness rather than to the instability of the relationship between exchange rates and fundamentals.