Do Divisia monetary aggregates help forecast exchange rates in a negative interest rate environment?

Abstract

This paper contributes to the literature as the first work of its kind to examine the role and importance of Divisia monetary aggregates and concomitant user cost price indices as superior monetary policy fore casting tools in a negative interest rate environment. We compare the performance of Divisia monetary aggregates with traditional simple-sum aggregates in several theoretical models and in a Bayesian VAR to forecast the exchange rates between the euro, the dollar and yuan renminbi at various horizons using quarterly data. We evaluate their performance against that of a random-walk using two criteria: Root Mean Square Error ratios and the Diebold-Mariano statistic. We find that, under a free-floating exchange regime, superior Divisia monetary aggregates outperform their simple sum counterparts and the bench mark random walk in negative interest rate environment and non-negative interest rate environments, consistently.