Publication: The failure of the monetary model of exchange rate determination
Full text at PDC
Advisors (or tutors)
Asociación Española de Economía y Finanzas Internacionales
In this paper, we test three popular versions of the monetary model (flexible price, forward-looking and real interest differential models) for the OECD member countries by applying Johansen cointegration technique. Based on country-by-country analysis, we conclude that monetary models do not provide the expected results. We reveal several shortcomings of the models and examine the building blocks of the fundamental version. Although researchers always blame the deviations from purchasing power parity as the reason for the failure of the monetary model, our analysis indicates that invalidity of Keynesian money demand function is also responsible for unfavourable results.
Baillie, R.T. and Selover, D.D. (1987) Cointegration and Models of Exchange Rate Determination, International Journal of Forecasting, 3(1), 43–51. Bilson, J.F.O. (1978) Rational expectations and the exchange rate, The Economics of Exchange Rates in (Eds.) J. A. Frenkel and H. G. Johnson (eds), Addison-Wesley, Reading, MA, 75-96. Cagan, P. (1956) The monetary dynamics of hyperinflation, Studies in the quantity theory of money, ed. by Friedman, M., 25-117, University of Chicago Press, Chicago. Cerra, V. and Saxena, S. C. (2010) The monetary model strikes back: Evidence from the world, Journal of International Economics, 81, 184–196. Cheung, Y.-W. and Chinn, M. D. (1998) Integration, Cointegration and the Forecast Consistency of Structural Exchange Rate Models, Journal of International Money and Finance, 17, 813-830. Cheung, Y.-W., Chinn, M. D. and Garcia Pascual, A. (2005) Empirical exchange rate models of the nineties: are Any fit to survive?, Journal of International Money and Finance, 24, 1150-1175. Chinn, M. D. and Meese, R. A. (1995) Banking on currency forecasts: How predictable is change in money, Journal of International Economics, 38, 161-178. Dornbusch, R. (1976) Expectations and exchange rate dynamics, Journal of Political Economy, 84, 1161-1176. Eichengreen, B. (2005) Sterling’s past, Dollar’s future: historical perspectives on reserve currency competition, National Bureau of Economic Research, Washigton, DC. Working Paper 11336. Frankel, J.A. (1979) On the Mark: A theory of floating exchange rates based on real interest differentials, American Economic Review, 69, 610-622. Frenkel, J. (1976) A monetary approach to the exchange rate: Doctrinal aspects and empirical evidence, Scandinavian Journal of Economics, 76, 200-224. Groen, J.J.J. (2000) The monetary exchange rate model as a long-run phenomenon, Journal of International Economics, 52, 299–319. Gujarati, D. N. and Porter, D. C. (2009) Basic Econometrics, McGraw Hill International Edition, 5, 741. Helleiner, E. (2008) Political determinants of international currencies: what future for the US Dollar?, Review of International Political Economy, 15, 354–378. Hooper, P. and Morton, J. (1982) Fluctuations in the Dollar: A Model of Nominal and Real Exchange Rate Determination, Journal of International Money and Finance, 1, 39–56. Hunter, J. and Menla Ali, F. (2014) Money demand instability and real exchange rate persistence in the monetary model of USD–JPY exchange rate, Economic Modelling, 40, 42–51. Husted, S. and MacDonald, R. (1998) Monetary-based models of the exchange rate: A panel perspective, Journal of International Financial Markets, Institutions and Money, 8, 1–19. Huynh, K. P. and Schmidt-Dengler,P. (2014) The Role of Card Acceptance in the Transaction Demand for Money, Center for Economic Policy Research, London, Discussion Paper 10183. Hwang, J.K. (2001) Dynamic forecasting of monetary exchange rate models: evidence from cointegration, International Advances in Economic Research, 7, 51-64. Johansen, S. (1988) Statistical analysis of cointegration vectors, Journal of Economic Dynamics and Control, 12, 231-254. Johansen, S. and Juselius, K. (1990) Maximum likelihood estimation and inference on cointegration-with applications to the demand for money, Oxford Bulletin of Economics and Statistics, 52, 169-210. Kearney, C. and MacDonald, R. (1990) Rational Expectations, Bubbles and Monetary Models of the Exchange Rate: The Australian/US dollar Rate during the Recent Float, Australian Economic Papers, 44, 1-20. Ketenci, N. and Uz, I. (2008) Panel analysis of the monetary approach to exchange rates: Evidence from ten new EU members and Turkey, Emerging Markets Review, 9(1), 57-69. Lucas, R. E. and Nicolini, J. P. (2015) On the Stability of Money Demand, Federal Reserve Bank of Minneapolis, Working Paper 718. MacDonald, R. (2007) Exchange Rate Economics. Theories and evidence, Routledge, London. MacDonald, R. and Taylor, M. P. (1992) The Monetary Approach to the Exchange Rate: Rational Expectations, Long-Run Equilibrium, and Forecasting, IMF Working Paper, 92/34. MacDonald, R. and Taylor, M. P. (1994) The Monetary Model of the Exchange Rate: Long-run Relationships, Short-run Dynamics and How to Beat a Random Walk, Journal of International Money and Finance, 13, 276–90. Meese, R. A. and Rogoff, K. (1983a) Empirical exchange rate models of the seventies: Do they fit out-ofsample?, Journal of International Economics, 14, 3-24. Meese, R. A. and Rogoff, K. (1983b) The out-of-sample failure of empirical exchange rate models: sampling error or mis-specification?, Exchange Rates and International Macroeconomics, (Ed) J. Frenkel, University of Chicago Press, Chicago, 67-105. Mussa, M. (1976) The exchange rate, the balance of payments, and monetary and fiscal policy under a regime of controlled floating, Scandinavian Journal of Economics, 78, 229-248. Neely, C. J. and Sarno, L. (2002) How Well Do Monetary Fundamentals Forecast Exchange Rates?, Federal Reserve Bank of St. Louis Review, 84(5), 51-74. Phillips, P.C.B. (1987) Time Series Regression with a Unit Root, Econometrica, 55, 277-301. Phillips, P.C.B. and Perron, P. (1988) Testing for a Unit Root in Time Series Regression, Biometrika, 75, 335-346. Rapach, D.E. and Wohar, M.E. (2004) Testing the monetary model of exchange rate determination: a closer look at panels, Journal of International Money and Finance, 23, 867–895. Sarno, L. and Taylor, M. P. (2002) The Economics of Exchange Rates, Cambridge University Press, Cambridge. Smith, P and Wickens, M. (1984) An Empirical Investigation into the Causes of the Failure of the Monetary Model of the Exchange Rate, Centre for Economic Policy Research, London. Sosvilla-Rivero, S. and García, E. (2006) Purchasing power parity revisited, International Macroeconomics: Recent Developments, (ed.) A. Morales Zumaquero, Nova Science Publishers, New York, 1-37.