Modelling Expectations

Expectations play an important role in the monetary models of exchange rates because the long-run expected inflation rate is an explanatory variable in both the Dornbusch-Frankel and the Hooper-Morton models. This is why it has been suggested that improper modelling of inflationary expectations may explain the Meese-Rogoff puzzle. However, we find that regardless of how inflationary expectations are measured, the random walk cannot be outperformed in terms of the magnitude of the forecasting error. Very little happens to measures of forecasting accuracy as we change the specification of the expectation formation mechanism in either of the two models. The Meese-Rogoff puzzle cannot be resolved by changing the specification of the expectation formation mechanism as long as the RMSE is used to measure forecasting accuracy.