The Monetary Approach to the Exchange Rate: Rational Expectations, Long-Run Equilibrium and Forecasting

IMF Working Papers, May 1, 1992

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Canonical URL: The Monetary Approach to the Exchange Rate: Rational Expectations, Long-Run Equilibrium and Forecasting

Re-examines the monetary approach to the exchange rate using monthly data on the deutschemark-dollar exchange rate.
Using the Campbell-Shiller technique for testing present value models, the authors reject the restrictions imposed upon the data by the forward-looking rational expectations monetary model.
The monetary model is validated as a long-run equilibrium condition.
Imposing the long-run monetary model restrictions in a dynamic error correction framework yields exchange rate forecasts superior to those generated by a random walk forecasting model.

Data: monthly deutschemark-dollar exchange rate.
Testing approach: Campbell-Shiller technique for present value models.
Findings:
- Rejection of forward-looking rational expectations monetary model restrictions when tested against the data.
- Validation of the monetary model as a long-run equilibrium relationship.
- Dynamic error correction framework that incorporates long-run monetary model restrictions improves forecast performance relative to a random walk.

Forecasts generated from a dynamic error correction model that enforces long-run monetary model restrictions outperform random walk forecasts for the deutschemark-dollar exchange rate.

Subject: Econometric analysis; Exchange rate assessments; Exchange rate modelling; Exchange rates; Foreign exchange; National accounts; Personal income; Vector autoregression
Keywords: dynamic error; exchange rate; Exchange rate assessments; Exchange rate modelling; Exchange rates; integrating vector; likelihood ratio statistic; Personal income; Phillips-Perron statistics; test statistic; time series; Vector autoregression; WP