Exchange Rate Economics: Theories and Evidence

148 Empirical evidence on the monetary approach
use the econometric methods of Johansen (1995) to determine the number of
significant cointegrating vectors and also to place interpretable restrictions on the
data. The money market relationship for the EU and US areas is analysed using
the following vector,which represents a subset of the gross vector (6.22):
x m′
t =[(m t − p t ), y t , i t , p t ] ′ ,(6.23)
where variables have the same interpretation as before. 5 Using the trace test of
Johansen there was evidence of two significant cointegrating vectors for the EU
and US systems and La Cour and MacDonald then implement joint hypothesis
tests of the following form on the full cointegrating space (see Johansen and Juselius
1992):
Hypothesis : β ={H 1 φ 1 , H 2 φ 2 },
this can be seen as the joint selection of two stationary relationships which are fully
specified and identified. The results from this testing strategy produces a simple
money market equation for the EU of the form
m t − p t =−10.55 ∗ i t . (6.24)
Equation (6.24) indicates that real money balances are negatively related to
the opportunity cost variable,as standard monetary theory would predict. The
fact that income is insignificant in this money demand relation was unexpected,
and probably reflected the small variation in this variable for the relatively short
time span of the sample period. For the second vector,a stationary relationship
between inflation and the interest rate,as suggested by the Fisher relationship,
was shown to hold 6 and the test of the joint hypothesis that these two vectors
define the cointegration space has a test statistic of 0.93,with a p-value of 0.63.
A similar relationship is shown to hold for the US. Following this specific-togeneral
approach,La Cour and MacDonald are able to identify the five significant
cointegrating vectors in the gross system (6.22):
m t − p t =−3.50i t ,(6.25)
(0.66)
m ∗ t − p ∗ t =−15.78i ∗ t
(1.15)
,(6.25 ′ )
p t = i t ,(6.26)
p ∗ t = i ∗ t ,(6.26′ )
s t − p t + p ∗ t =−19.51i t
(1.63)
+ 46.58
(2.77) i∗ t ,(6.27)
where standard errors are in brackets. Equations (6.25) and (6.25 ′ ) represent
EU and US money demand relationships,respectively,and they have the
same specification as that recovered from the partial system discussed earlier.