Comparative Analysis of the Portfolio-balance Models of Exchange Rate Determination

Abstract

The current study conducts a comparative analysis of Portfolio-Balance Models (PBM) developed by Branson, Kouri and Dornbusch to assess the role of expectations and time horizons in determining and forecasting the India–US exchange rate over the period 1996:Q2–2019:Q3. Notably, it improves the original models by integrating microstructure theory into their framework. The Autoregressive Distributed Lag Error-Correction Model (ARDL-ECM) is used to investigate both short run and long run behaviour of the models. Additionally, the study assesses out-of-sample forecasting accuracy of the modified models against the Random Walk Model (RWM) using the root mean square error metric. The estimation results reveal that models based on rational expectations are better than the static expectations model. Notably, the microeconomic determinant is counterintuitively significant only in the long run across all models. Furthermore, these modified models demonstrate superior out-of-sample forecasting abilities compared to RWM for alternative forecasting horizons. However, forecasting results over a 6-month period is better with short run models. Over 1-year and 2-year horizons, rational expectations models outperform the static expectations model. This study challenges the Meese–Rogoff puzzle, ensuring that PBM, when modified to incorporate microstructure theory, is valid and yields superior forecasting results compared to RWM.

JEL Codes: F31, F32, C22