Mean reversion in real exchange rates: Evidence and implications for forecasting

The stationarity of real exchange rates over the recent flexible exchange rate period is an issue that has long bedeviled researchers in international finance. Using a constrained multivariate framework, this paper provides the strongest evidence yet that real exchange rates were mean-reverting over the 1973-93 period. We also investigate shifts in long-run real exchange rates, which may be important for the purpose of forecasting. Out-of-sample forecasting shows that the random walk model is outperformed by a mean-stationary model, especially at long horizons. In addition, there are substantial forecasting benefits from using a multivariate approach. (JEL C22, F21). Copyright (C) 1996 Elsevier Science Ltd