Hysteresis and Averaging the Forecasts of Exchange Rates

Abstract

Real exchange rates evolve independently of money supply shocks in accordance with long-run monetary neutrality. However, the prolonged disequilibrium errors of the Korean won―US dollar real exchange rates in the 1990s prior to the Asian financial crisis and the hike subsequent to the crisis indicate hysteresis of the real exchange rates. The hysteresis may originate from two sources, namely, the instability of the equilibrium relationship and the regime-dependent persistence of real exchange rates. The current paper provides a statistical evaluation of the hysteresis in the won―dollar real exchange rates using forecast combination. The behavior of asymmetric mean reversion and regime-dependent persistence dominates the parameter instability in real exchange rates. A substantial improvement in predictive accuracy is observed as the forecasting model incorporates the hysteresis effect.