Academic journal article Economic Inquiry

Monetary Fundamentals and Exchange Rate Dynamics under Different Nominal Regimes

Academic journal article Economic Inquiry

Monetary Fundamentals and Exchange Rate Dynamics under Different Nominal Regimes

Article excerpt

I. INTRODUCTION

A large body of literature has examined the relationship between the nominal exchange rate and the fundamentals suggested by conventional theories of exchange rate determination using data for the modern floating exchange rate period. In general, these studies have found little support for this relationship. Specifically, on one hand, empirical work has often failed to find evidence of cointegration between the nominal exchange rate and monetary fundamentals--such as income differentials and money differentials (e.g., see Meese 1986; Baillie and Selover 1987; McNown and Wallace 1989; Baillie and Pecchenino 1991; Neely and Sarno 2002). On the other hand, those studies that have found evidence of cointegration between the nominal exchange rate and monetary fundamentals provide little support for the theoretical restrictions predicted by the exchange rate-monetary fundamentals relationship (e.g., Cushman 2000) or suggest that fundamentals are unable to predict more than a small amount of the variation in exchange rates (e.g., Mark 1995; Kilian 1999; Berkowitz and Giorgianni 2001; Mark and Sul 2001).

One reason for the inability to find evidence of a long-run relationship between the nominal exchange rate and monetary fundamentals is the low power of conventional statistical tests to reject a false null hypothesis of no cointegration with a sample span corresponding to the length of the recent float. Following the literature testing the validity of purchasing power parity (see Sarno and Taylor 2002a,b), two responses to the low power of these tests have been brought forth in the extant literature. First, some researchers have sought to increase test power by using panel cointegration tests applied jointly to a number of exchange rate series over the recent float. In some of these studies, the no-cointegration null hypothesis can be rejected for several countries, thereby providing support for the existence of a meaningful long-run relationship between exchange rates and monetary fundamentals (e.g., Groen 2000; Mark and Sul 2001).

Second, other researchers have sought to increase the power of their tests by increasing the length of the sample period under investigation. Rapach and Wohar (2002) take this alternative approach and apply a battery of unit root and cointegration tests to annual time series dating back to the late 19th century for 14 industrialized countries, reporting mixed results on the validity of the exchange rate-monetary fundamentals relationship. (1) Rapach and Wohar (2002) also investigate whether exchange rates or fundamentals adjust when there is a deviation away from long-run equilibrium. They find that departures from equilibrium may be restored via movements in the exchange rate or in fundamentals or both, suggesting that fundamentals may not be weakly exogenous with respect to the exchange rate. This evidence lends some support to the argument, put forth in a recent provocative paper by Engel and West (2002), that for countries and data where exchange rates and fundamentals appear to be linked by a long-run relationship, it may be the case that exchange rates help predict fundamentals, rather than the other way around.

In light of this evidence, there remain at least two important questions in this line of research. First, regardless of the relative success of some recent panel cointegration studies (e.g., Groen 2000; Mark and Sul 2001), it is controversial whether the exchange rate monetary fundamentals relationship is validated by the data. Second, it is debatable whether, when the exchange rate monetary fundamentals relationship is validated by the data, adjustment toward the long-run equilibrium level defined by this relationship is driven primarily by the exchange rate or by the fundamentals. The latter question is not only relevant empirically, given the lack of consensus in the literature on whether fundamentals and/or exchange rates are exogenous to each other but also theoretically. …

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