Macroeconomic Fundamentals and the DM/$ Exchange Rate: Imperfect Knowledge and the Monetary Model

Despite the volumes written on the failure of empirical exchange rate models, there is a key feature of the record that is much overlooked, namely there are some subperiods of floating rates during which macroeconomic models provide reasonable explanations of monthly or quarterly exchange rate movements and other subperiods during which the explanatory power of these models completely disappears. Frankel [1979], for example, found an overshooting model of the DM/$ exchange rate fitted remarkably well in-sample during the mid-1970s. But when Frankel’s sample was updated to include the late 1970s and 1980s, researchers found a lack of cointegrating relationships (e.g., Meese and Rogoff [1988] and Boothe and Glassman [1987]) and parameter estimates that were either insignificant or significant and of the wrong sign (e.g., Frankel [1983,1984] and Backus [1984]). By the 1990s, more powerful dynamic approaches to estimating and testing for cointegrating relationships had been developed (e.g., Johansen [1988]) and Phillips [1992]), but again some studies found evidence of cointegrating relationships (e.g., MacDonald and Taylor [1994], MacDonald and Marsh [1997] and Cushman, Lee and Thorgeirson [1996]), while others using different sample periods did not (Baillie and Pecchenino [1991] and Papell [1987]). This temporal inconsistency is also prevalent in out-of-sample forecasting exercises. The seminal study of Meese and Rogoff [1983] showed an inability of exchange rate models to outperform the random walk model in out-of-sample forecasting over a sample that included the early 1980s. When this study was updated to include the 1990s and the use of dynamic models, some researchers found the structural models outperformed the random walk model at shorter forecasting horizons (e.g., MacDonald and Taylor [1994] and MacDonald and Marsh [1997], while others using similar methodologies but different sample periods found the random walk still dominated (e.g., Chinn and Meese [1995].1