Exchange Rate Economics: Theories and Evidence

162 Empirical evidence on the monetary approach
forward-looking model in which interest rates are excluded from the cointegrating
set and a very tightly defined relationship of the following form could be recovered:
s t = m t − m ∗ t − (y t − y ∗ t ),
where the restriction that the coefficients on the relative money supply and income
terms were unity could not be rejected. The monetary model therefore passes
the first of the present value tests. However,the remaining set of tests are not so
favourably deposed to the model.
The forward-looking restrictions were implemented for a range of four different
values for the semi-interest elasticity of the demand for money and in each case
the restrictions were rejected with a p-value of 0.00. Furthermore,the variance
inequality (6.51) was actually reversed in each case – that is,empirically it turns out
that Var(ζ t ) ≥ Var(ˆζ t ). Finally,in Figure 6.1 we plot the actual spread alongside
its theoretical counterpart and it is clear that both ˆζ t and ζ t are very different,and
therefore the model would also seem to fail this qualitative test.
Engel and West (2003) also exploit a Campbell–Shiller type present value model
to demonstrate that under certain assumption one implication of this model is that
the exchange rate should Granger cause fundamentals. Using quarterly data for
the G7 over the period 1974:1–2001:3 they demonstrate quite a bit of evidence of
Granger causality running from the US dollar bilateral exchange rates and fundamentals
extracted from a standard monetary model (i.e. relative money supplies
0.48
0.36
Actual
0.24
0.12
0
Theoretical
–0.12
–0.24
–0.36
1976 1978 1980 1982
1984 1986 1988 1990
Figure 6.1 Actual and theoretical spread.
Source: MacDonald and Taylor (1993).