Exchange Rate Economics: Theories and Evidence

Empirical evidence on the monetary approach 141
A second explanation for the poor performance of the monetary model has been
given by Frankel (1982c): he attempts to explain the mystery of the multiplying
marks by introducing wealth into the money demand equations. The justification
for this inclusion is that Germany was running a current account surplus in
the late 1970s and this was redistributing wealth from US residents to German
residents thus increasing the demand for marks,and reducing the demand for
dollars,independently of the other arguments in the money demand functions. By
including home and foreign wealth (defined as the sum of government debt and
cumulated current account surpluses) in equation (6.11),and by not constraining
the income,wealth and inflation terms to have equal and opposite signs,Frankel
(1982c) reports a monetary approach equation in which all variables,apart from
the income terms,are correctly signed and most are statistically significant; the
explanatory power of the equation is also good.
A further explanation for the failure of the monetary approach equations may
be traced to the relative instability of the money demand functions underlying
reduced forms such as (6.1). Thus a number of single-country money demand
studies strongly indicate that there have been shifts in velocity for the measures of
money utilised by the researchers mentioned earlier (see Artis and Lewis 1981 for a
discussion). In Frankel (1984),shifts in money demand functions are incorporated
into equation (6.11) by introducing a relative velocity shift term v − v ∗ ,which is
modelled by a distributed lag of (p + y − m) − (p ∗ + y ∗ − m ∗ ). The inclusion of the
v −v ∗ term in equation (6.11) (along with a term capturing the real exchange rate –
the inclusion of such a term in an asset reduced form will be considered in the next
chapter) for five currencies leads to most of the monetary variables becoming
statistically significant and of the correct sign. However,significant first-order
serial correlation is a problem in all of the reported equations.
Driskell and Sheffrin (1981) argue that the poor performance of the monetary
model can be traced to a failure to account for the simultaneous bias introduced by
having the expected change in the exchange rate (implicitly through the relative
interest rate term) on the right hand side of monetary equations. However,taking
account of this in a rational expectations framework Driskell and Sheffrin (1981)
find no support for the RID monetary model and suggest that the reason for its
failure may lie in an assumption underlying all the monetary models: namely,that
assets are perfect substitutes. The latter suggestion implies that an additional variable,such
as a risk premium,may need to be included into a monetary model. This
line of argument supports our earlier contention that the persistent autocorrelation
reported in monetary models is suggestive of model misspecification.
6.2.3 Out-of-sample evidence: the Meese and Rogoff critique
As we have seen,once observations from the 1980s are included into estimated
reduced-form monetary exchange rate models,the in-sample performance of the
models break down. Perhaps the most devastating indictment against the monetary
model to come from the early empirical evidence was that of Meese and Rogoff
(1983),who examined the out-of-sample forecasting performance of the model.