Exchange Rate Economics: Theories and Evidence

Empirical evidence on the monetary approach 163
and relative income levels) and a monetary model extend to include a Taylor
rule (which introduces relative interest rates as an extra fundamental). However,
they find little evidence of causality running in the opposite direction,from fundamentals
to exchange rates,which seems to confirm the exchange rate disconnect.
The Granger causality results are shown to be robust with respect to both bivariate
and multivariate pairings. Engel and West,however,recognise that since the
present value model is a reduced-form relationship the Granger causality between
exchange rates and fundamentals could be reflective of other factors (i.e. it could
be that exchange rates Granger cause money supplies because central banks react
to the exchange rate in setting monetary policy). Engel and West also demonstrate
analytically that in the context of a rational expectations present value model that
the exchange rate can exhibit near random walk behaviour if fundamentals are I (1)
and the discounting factor,from the present value relationship,is close to unity.
In sum,the forward-looking monetary model does not seem to offer the means of
explaining the phenomenon of intra-regime volatility. The forward-looking model
is considered again in Chapter 11,after we have introduced the New Open Economy
Macroeconomic models,and as we shall see there,variants of the model to
appear to offer an interesting explanation for intra-regime exchange rate volatility
in terms of uncertainty. We close this Chapter by asking the question: can the monetary
model be used to explain the issue of inter-regime volatility first introduced
in Chapter 1?
6.5 Inter-regime volatility
Baxter and Stockman (1989) were the first to examine the variability of output,trade
variables and private and government consumption across the Bretton
Woods and post-Bretton Woods experience and they were:
unable to find evidence that the cyclic behavior of real macroeconomic aggregates
depends systematically on the exchange rate regime. The only exception
is the well known case of the real exchange rate.
That is to say as countries move from fixed to flexible exchange rates the volatility
of macroeconomic fundamentals does not change but the volatility of the real
(and nominal) exchange rate does change. Flood and Rose (1995) re-examine the
issue of inter-regime volatility using the monetary model. Specifically,Flood and
Rose (1995) construct what they refer to as Virtual Fundamentals (VF) and Total
Fundamentals (TF). Consider again the base-line monetary equation:
s t = m t − m ∗ t − β 0 (y t − y ∗ t ) + β 1(i t − i ∗ t ),
which can be rearranged as:
s t − β 1 (i t − i ∗ t ) = m t − m ∗ t − β 0 (y t − y ∗ t ),