The Monetary Exchange Rate Model: Long-run, Short-run, and Forecasting Performance

Abstract

This paper examines the monetary model of exchange rate determination for the US dollar exchange rates against the currencies of Canada, Japan, and the United Kingdom. In this paper, we utilize the cointegration technique for testing long-run relationship, and vector error correction model for short-run dynamics and out-of sample forecasting. The existence of cointegration supports the long-run relationship among nominal exchange rate and a number of fundamental variables. The out-of sample forecasting indicates that the nominal exchange rate forecasts from the VEC monetary model can be superior to random-walk based forecasts in a projection period of less than one year. This conclusion implies that the monetary model of exchange rate determination is a reliable tool for policy makers to evaluate their currency and the monetary authority should expect a much shortened response time to the monetary policy impulse in the surging trend of international economic integration.