Exchange Rate Economics: Theories and Evidence

Empirical evidence on the monetary approach 157
outperforms a random walk,by a mean squared error criterion; however,along
a direction-of change dimension,certain structural models do outperform a random
walk with statistical significance.’ In the light of our discussion earlier this
result seems surprising especially since Cheung et al. use an error correction specification,in
addition to a first difference specification. However,crucially,the
error correction models estimated are not rendered parsimonious by the deletion
of insignificant dynamics and MacDonald and Marsh have shown this aspect
of exchange rate modelling is extremely important in the process of obtaining
accurate exchange rate forecasts.
We believe that the research presented in this section demonstrates clearly that
the random walk paradigm no longer rules the roost in terms of exchange rate
forecasting. There is now a sufficient body of evidence to suggest that the random
walk can be beaten in a large variety of samples and for a number of different
currencies. This of course is not to say that the random walk model can always be
beaten,but it does,at least,indicate that the pessimism that many have levelled
against fundamentals-based exchange rate models is unwarranted.
6.4 Does the forward-looking monetarymodel
explain exchange rate volatility?
As we saw in Chapter 4,the forward-looking monetary model offers a potentially
attractive way of explaining exchange rate volatility. In this section we consider
some of the empirical evidence which seeks to test the forward-looking variant of
the monetary model.
The earliest test of the forward-looking monetary model was conducted by
Huang (1981) who implemented so-called variance inequality tests of the form:
s t ≤ x t ,
that is,the volatility of the monetary fundamentals,as captured by the variance,
should be at least as great as the volatility of the exchange rate. Using monthly
data for the period March 1973–March 1979,Huang for three bilateral exchange
rates (US dollar–DM,US dollar–pound sterling and pound–DM) demonstrated
that the inequality was in fact reversed: exchange rates are much more volatile
than fundamentals.
Arnold et al. (2005) examine the issue of intra-regime volatility for the post-
Bretton Woods regime. Specifically,they construct standard deviations of s and
f ,where f is a composite measure of fundamentals,such as [(m−m ∗ )−(y−y ∗ )],
using both the US and Germany as alternate numeraires,for the post-Bretton
Woods period. The striking result from this study is that the order of magnitude
for the volatility in the total fundamentals is not very different to exchange rate
volatility.
Other tests of the forward-looking model rely on imposing restrictions on vector
autoregressive models. Such tests may be distinguished with respect to whether they
include cointegration restrictions in their tests or not. Tests which do not impose