ON COINTEGRATION AND EXCHANGE-RATE DYNAMICS

Baillie and Bollerslev (1989) have recently argued that nominal dollar spot exchange rates are cointegrated. Here we examine an immediate im plication of their finding, namely, that cointegration implies an erro r-correction representation yielding forecasts superior to those from a martingale benchmark, in light of a large earlier literature highlig hting the predictive superiority of the martingale. In an out-of-sampl e forecasting exercise, we find the martingale model to be superior. W e then perform a battery of improved cointegration tests and find that the evidence for cointegration is much less strong than previously th ought, a result consistent with the outcome of the forecasting exercis e.