Academic journal article Journal of Money, Credit & Banking

Exchange Rate Predictability and Monetary Fundamentals in a Small Multi-Country Panel

Academic journal article Journal of Money, Credit & Banking

Exchange Rate Predictability and Monetary Fundamentals in a Small Multi-Country Panel

Article excerpt

If monetary exchange rate models are valid representations of long-run exchange rate behavior then the exchange rate will only deviate from its monetary fundamentals in the short-run. The purpose of this study is to test the empirical validity of monetary fundamentals-based foreign exchange pricing, and in testing this we follow a two-tier route. First, we want to establish whether there is a long-run link between exchange rates and monetary fundamentals according to the monetary exchange rate model through cointegration tests. Next, we assess the predictive ability of monetary fundamentals for future exchange rate movements.

In our empirical analysis we focus on the Euro exchange rates of Canada, Japan, and the United States [U.S.] for the 1975-2000 period. The establishment of the European Monetary Union [EMU] in 1999 in our view provides the ultimate test of the forward-looking feature of the efficient market-based monetary model, as both the moment as well as the institutional set-up were publicly announced well in advance. The expected behavior of the EMU-based monetary fundamentals should therefore already have been discounted in the respective spot Euro exchange rates before 1 January 1999. For our proxy of both the Euro exchange rates as well as the EMU-based monetary fundamentals we at first make use of constructed synthetic EMU data from the seven major EMU member states. As a second alternative we follow Arnold and de Vries (2000) who suggests that the historical behavior of EMU money demand can best be approximated by extrapolating the behavior of the country which mimics the European Central Bank's [ECB] line of conduct best instead of constructing artificial synthetic EMU data. Hence, we also use solely German data as a proxy of pre-1999 EMU behavior.

A number of recent studies, in particular Mark (1995) and Chinn and Meese (1995), tried to exploit the assumed long-run link between exchange rates and monetary fundamentals, and they claim that current monetary fundamentals-based disequilibria can predict the exchange rate 4 years ahead, both in-sample and out-of-sample for the U.S. dollar exchange rates of Canada, Germany, Japan, Switzerland, and the UK over the 1973-91 period. This long horizon predictability, however, breaks down in Groen (1999) for out-of-sample tests on these exchange rates within a 1973-94 sample. Groen relates his result to the absence of cointegration between exchange rates and monetary fundamentals, i.e., a stationary linear combination of the exchange rate and its monetary fundamentals is absent. Hence, the issue of cointegration is of major importance in establishing a predictable link between exchange rates and their monetary fundamentals.

Based on the cointegrated vector autoregressive [VAR] framework of Johansen (1991), however, Sarantis (1994) and Groen (2000) do not find evidence for cointegration based on the monetary model for a large number of OECD-countries' exchange rates relative to the U.S. dollar, the Deutsche Mark [DM], and the pound-sterling. On the other hand, Groen (2000) finds that the use of cross-section regressions for a large number of countries, or tests for cointegration within a fixed individual effect multi-country panel data model, result in more empirical evidence in favor of the monetary exchange rate model. Like Groen (2000), Mark and Sul (2001) use a panel of bilateral exchange rates for 17 OECD countries over the period 1973-97 to analyze the empirical features of the monetary model. The results in Mark and Sul indicate that there is cointegration based on the monetary model and that monetary fundamentals significantly predict future exchange rate returns using panel regression estimates with fixed time effects. Hence, the analysis of the monetary exchange rate model across multiple countries simultaneously seems to provide more positive results than the single country monetary model.

The panel cointegration frameworks described in Groen (2000) and Mark and Sul (2001) are essentially pooled versions of the two-step Engle and Granger (1987) procedure and therefore only allow for a limited amount of cross-country heterogeneity. …

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