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.