We would like to thank an anonymous referee for helpful comments. Bacchetta gratefully acknowledges financial support from the National Centre of Competence in Research “Financial Valuation and Risk Management”(NCCR FINRISK) and from the Swiss Finance Institute.
1This traditional money market equilibrium can easily be replaced by an interest rate rule, which is more typical in DSGE models. Equation 13.1 can be written as it = κ0 + κ1(pt − p) + κ2(yt − y) + κ3(mt − m). Often, other variables appear in interest rate rules, such as the current or expected inflation rate, but this does not fundamentally change the specification. It just involves replacing one fundamental variable in the interest rate rule, such as mt − m, with another fundamental variable, such as , where πt is the inflation rate.
2See for examples Beaudry and Portier (2006), Devereux and Engel (2006), Jaimovich and Rebelo (2008), and Lorenzoni (2010).
3More precisely, Meese and Rogoff (1983) estimate a linear exchange rate model based on standard fundamentals such as money supply, output, and interest rates. They use the estimated model to do a one-period-ahead forecast, but use the actual future fundamental (which implies this is not a true forecast). They do this for several periods using rolling regressions and compute the RMSE. They do the same exercise by predicting the exchange rate with a ...