Application of Taylor Rule Fundamentals in Forecasting Exchange Rates

Abstract

This paper examines the effectiveness of the Taylor rule in contemporary times by investigating the exchange rate forecastability of selected four Organisation for Economic Co-operation and Development (OECD) member countries vis-à-vis the U.S. It employs various Taylor rule models with a non-drift random walk using monthly data from 1995 to 2019. The efficacy of the model is demonstrated by analyzing the pre- and post-financial crisis periods for forecasting exchange rates. The out-of-sample forecast results reveal that the best performing model is the symmetric model with no interest rate smoothing, heterogeneous coefficients and a constant. In particular, the results show that for the pre-financial crisis period, the Taylor rule was effective. However, the post-financial crisis period shows that the Taylor rule is ineffective in forecasting exchange rates. In addition, the sensitivity analysis suggests that a small window size outperforms a larger window size.