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An Empirical Investigation into the Causes of the Failure of the Monetary Model of the Exchange Rate

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  • Smith, Peter N
  • Wickens, Michael R.

Abstract

A well known characteristic of flexible exchange rates is their volatility, with result that their movement can be closely approximated by a random walk. One of the attractions of the monetary model of the exchange rate is its ability to offer an explanation of this volatility. A major drawback is that empirical tests of the exchange rate equation arising from the monetary model very often lead to rejection of the model. The blame for this is usually attributed to the breakdown of the purchasing power parity assumption. The main purpose of this paper is to attempt to provide measures of the relative importance of the likely principal causes of the failure of the monetary model. A second objective is to test the random walk hypothesis for exchange rates. The methodology employed is new and has wide application elsewhere. It involves explicitly modelling the misspecification by time series techniques. The results, which are for the sterling-United States Dollar and Deutschemark-United States Dollar exchange rates, confirm the importance of the breakdown of the PPP assumption but they also show that misspecification of the money market is equally important. Whilst a random walk model is found to provide a very good fit, it is shown that lagged information can be used to improve the explanation of the spot exchange rate and hence the random walk hypothesis can be rejected.

Suggested Citation

  • Smith, Peter N & Wickens, Michael R., 1984. "An Empirical Investigation into the Causes of the Failure of the Monetary Model of the Exchange Rate," CEPR Discussion Papers 7, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:7
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    Cited by:

    1. Din 祲 Afat & Marta G -Puig & Sim osvilla-Rivero, 2015. "The failure of the monetary model of exchange rate determination," Applied Economics, Taylor & Francis Journals, vol. 47(43), pages 4607-4629, September.
    2. Rakesh K. Bissoondeeal & Michail Karoglou & Alicia M. Gazely, 2011. "Forecasting The Uk/Us Exchange Rate With Divisia Monetary Models And Neural Networks," Scottish Journal of Political Economy, Scottish Economic Society, vol. 58(1), pages 127-152, February.
    3. Hoda SELIM, 2010. "Has Egypt's Monetary Policy Changed after the Float?," EcoMod2010 259600152, EcoMod.
    4. Kisu Simwaka, 2004. "Monetary Model of exchange rate: empirical evidence from Malawi," Macroeconomics 0407019, University Library of Munich, Germany.
    5. de Souza Vasconcelos, Camila & Hadad Júnior, Eli, 2023. "Forecasting exchange rate: A bibliometric and content analysis," International Review of Economics & Finance, Elsevier, vol. 83(C), pages 607-628.
    6. Nusrate Aziz & Arusha Cooray & Wing Leong Teo, 2021. "Do immigrants’ funds affect the exchange rate?," The World Economy, Wiley Blackwell, vol. 44(2), pages 560-585, February.
    7. Carlos Eduardo Castillo-Maldonado & Fidel Pérez-Macal, 2013. "Assessment of models to forecast exchange rates: The quetzal–U.S. dollar exchange rate," Journal of Applied Economics, Universidad del CEMA, vol. 16, pages 71-99, May.
    8. Beetsma, R.M.W.J., 1991. "Bands and Statistical Properties of EMS Exchange Rates: A Monte Carlo Investigation of Three Traget Zone Model," Papers 9160, Tilburg - Center for Economic Research.
    9. Dieter Nautz & Karsten Ruth, 2008. "Monetary disequilibria and the euro/dollar exchange rate," The European Journal of Finance, Taylor & Francis Journals, vol. 14(8), pages 701-716.

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