The Monetary Approach to Exchange Rate Modelling

  • Ronald MacDonald
  • Ian Marsh
Part of the Advanced Studies in Theoretical and Applied Econometrics book series (ASTA, volume 37)


In this chapter we turn to a fundamentals-based approach to modelling the nominal exchange rate which is closely associated with PPP, namely the monetary approach to the exchange rate. However, although various guises of the monetary approach — most notably the flexible price and sticky-price approaches — rely on PPP as a long-run construct, their motivation is quite different since they view the exchange rate as the relative price of two monies (i.e. assets), rather than purely the relative price of commodities. Interpreting the exchange rate in this way yields important insights into why floating exchange rates are more volatile than underlying economic fundamentals. This may be illustrated by referring to table 4.1, where the coefficients of variation of three series are presented for a number of representative countries. The series are: the log of the bilateral US dollar exchange rate; the log of the ratio of the country’s consumer price index (CPI) to the US CPI; the difference between the country’s three month euro-interest rate and that of the US (interest rates are expressed as proportions).1


Exchange Rate Interest Rate Real Exchange Rate Money Supply Money Demand 
These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.


Unable to display preview. Download preview PDF.

Unable to display preview. Download preview PDF.


  1. Baillie, R.T. and D.D. Selover (1987) “Cointegration and models of exchange rate determination,” International Journal of Forecasting, Vol. 3, 43–51.CrossRefGoogle Scholar
  2. Boothe, P. and D. Glassman (1987) “Off the mark: lessons for exchange rate modelling,” Oxford Economic Papers, Vol. 39, 443–457.Google Scholar
  3. Chow, G.C. (1960) “Tests of equality between sets of coefficients in two linear regressions,” Econometrica, Vol. 28, 591–605.CrossRefGoogle Scholar
  4. Doornik, J. and H. Hansen (1994) “A practical test of multivariate normality”, unpublished paper, Nuffield College, Oxford.Google Scholar
  5. Dornbusch, R. (1976) “Expectations and exchange rate dynamics, Journal ofPolitical Economy, Vol. 84, 1161–1176.CrossRefGoogle Scholar
  6. Frankel, J.A. (1979) “On the mark: a theory of floating exchange rates based on real interest differentials,” American Economic Review, Vol. 69, 610–622.Google Scholar
  7. Frankel, J.A and A. Rose (1995) “A Survey of Empirical Research on Nominal Exchange Rates” in The handbook of international economics by G. Grossman and K. Rogoff (eds), Vol. 3, North Holland: Amsterdam.Google Scholar
  8. Ghosh, A. (1991) “Accounting for real exchange rate movements in the short-run and in the long-run,” mimeo, Princeton University.Google Scholar
  9. Godfrey, L.G. (1988) Misspecification tests in econometrics, Cambridge University Press: Cambridge.Google Scholar
  10. Hendry, D.F. (1979) “Predictive failure and econometric modelling,” in Economic modelling by P. Ormerod (ed.), Heinemann: London.Google Scholar
  11. Hendry, D.F. and G.E. Mizon (1993) “Evaluating dynamic econometric models by encompassing the VAR,” in Models, methods and applications of econometrics: essays in honor of A.R. Bergstrom by P.C.B. Phillips (Ed.), Blackwell: Oxford.Google Scholar
  12. Hodrick, R.J. (1978) “An empirical analysis of the monetary approach to the determination of the exchange rate,” in The economics of exchange rates by J.A. Frenkel and H.G. Johnson (Eds.), Addison-Wesley: Reading, Mass.Google Scholar
  13. Hoffman, D. and D. Schlagenhauf (1983) “Rational expectations and monetary models of exchange rate determination: an empirical analysis,” Journal of Monetary Economics, Vol. 11, 247–260.CrossRefGoogle Scholar
  14. Johansen, S. (1995), Likelihood-based inference in cointegratedvector autoregressive models, Oxford University Press: Oxford.CrossRefGoogle Scholar
  15. Johansen, S. and K. Juselius (1992) “Testing structural hypotheses in a multivariate cointegration analysis of the PPP and UIP for UK,” Journal of Econometrics, Vol. 53, 211–244.CrossRefGoogle Scholar
  16. Kearney, C.P. and R. MacDonald (1986) “Intervention and sterilisation under floating exchange rates,” European economic Review, Vol. 30, 345–364.CrossRefGoogle Scholar
  17. Kearney, C.P. and R. MacDonald (1990) “Rational expectations, bubbles and monetary models of the exchange rate: the Australian—US dollar under the recent float,” Australian Economic Papers, Vol. 44, 1–20.CrossRefGoogle Scholar
  18. La Cour, L. and R. MacDonald (1998) “Modelling the ECU against the US dollar: a structural monetary approach,” mimeo, University of Strathclyde.Google Scholar
  19. Laidler, D. (1992), The demand for money, Harper-Collins: New York.Google Scholar
  20. Lutkepohl H. (1993) Introduction to multiple time series analysis, Springer-Verlag: Berlin.CrossRefGoogle Scholar
  21. MacDonald, R. (1988) Floating exchange rates: theories and evidence, UnwinHyman: London.CrossRefGoogle Scholar
  22. MacDonald, R. and I.W. Marsh (1997) “On fundamentals and exchange rates: a Casselian perspective,” Review of Economics and Statistics, Vol. 79, 655–664.CrossRefGoogle Scholar
  23. MacDonald, R. and M.P. Taylor (1991) “The monetary approach to the exchange rate: long-run relationships and coefficient restrictions,” Economics Letters, Vol. 37, 179–185.CrossRefGoogle Scholar
  24. MacDonald, R. and M.P. Taylor (1992) “Exchange rate economics: a survey,” International Monetary Fund Staff Papers, Vol. 39, 1–57.CrossRefGoogle Scholar
  25. MacDonald, R. and M.P. Taylor (1993) “The monetary approach to the exchange rate: rational expectations, long-run equilibrium and forecasting,” International Monetary Fund Staff Papers, Vol. 40, 89–107.CrossRefGoogle Scholar
  26. MacDonald, R. and M.P. Taylor (1994) “The monetary model of the exchange rate: long-run relationships, short-run dynamics and how to beat a random walk,” Journal of International Money and Finance, Vol. 13, 267–276.CrossRefGoogle Scholar
  27. Meese, R.A. (1986) “Testing for bubbles: a case of sparkling rates?” Journal of International Economics, Vol. 94, 345–373.Google Scholar
  28. Meese, R.A. and K. Rogoff (1983) “Empirical exchange rate models of the seventies: do they fit out-of-sample?” Journal of International Economics, Vol. 14, 3–24.CrossRefGoogle Scholar
  29. Sarantis, N. (1994) “The monetary exchange-rate model in the long-run: an empirical investigation,” Weltwirtschaftliches Archiv, Vol. 130, 698–711.CrossRefGoogle Scholar
  30. Schinasi, G.J. and P.A.V.B. Swamy (1987) “The out-of-sample forecasting performance of exchange rate models when coefficients are allowed to change,” Journal of International Money and Finance, Vol. 8, 375–390.CrossRefGoogle Scholar
  31. Wolff, C.C.P. (1987) “Time-varying parameters and the out-of-sample forecasting performance of structural exchange rate models,” Journal of Business and Economic Statistics, Vol. 5, 87–98.Google Scholar

Copyright information

© Springer Science+Business Media Dordrecht 1999

Authors and Affiliations

  • Ronald MacDonald
    • 1
  • Ian Marsh
    • 2
  1. 1.University of StrathclydeUK
  2. 2.City University Business SchoolUK

Personalised recommendations