Model Misspecification

Model misspecification is put forward as a possible explanation for the Meese-Rogoff puzzle, in the sense that models fail to outperform the random walk because they are misspecified. However, three variations of exchange rate determination models (the post-Keynesian flow model, a version of the F-B model that distinguishes between traded and non-traded goods, and the F-B, D-F and H-M models without the proportionality and symmetry restrictions) cannot outperform the random walk in terms of the magnitude of the forecasting error. In contrast, when the forecasts of the three models are assessed by alternative measures of forecasting accuracy, a different conclusion is reached. The random walk can be outperformed by alternative model specifications only if forecasting accuracy is assessed by measures that do not rely exclusively on the magnitude of error.