Money demand instability and real exchange rate persistence in the monetary model of USD¬タモJPY exchange rate

a r t i c l e i n f o This paper proposes a hybrid monetary model of the dollar–yen exchange rate that takes into account factors affecting the conventional monetary model's building blocks. In particular, the hybrid monetary model is based on the incorporation of real stock prices to enhance money demand stability and also, productivity differential, relative government spending, and real oil price to explain real exchange rate persistence. By using quarterly data over a period of high international capital mobility and volatility (1980:01–2009:04), the results show that the proposed hybrid model provides a coherent long-run relation to explain the dollar–yen exchange rate as opposed to the conventional monetary model. Since the collapse of the Bretton Woods fixed exchange rate system in 1971, much attention has been paid towards finding a meaningful explanation of exchange rates. A wide range of models have been proposed to understand movements in the exchange rate, one of which is the monetary model (see Bilson, 1978; Frankel, 1979). Despite its rigorous theoretical underpinnings by linking the nominal exchange rate to its monetary fundamentals (e.g., money, income, and interest rates), the resulting reduced form has had limited empirical success until now. For example, although MacDonald and Taylor (1994) provided evidence of a long-run relation between monetary fundamentals and nominal exchange rates, the signs and magnitudes of estimated coefficients did not support the related monetary theories. Groen (2000), and Mark and Sul (2001) among others also found some evidence in a panel context, but this was under the assumption of a high order of heterogeneity across the country models. Similarly, Rapach and Wohar (2002) found some support for the theory using long time series, but this was related to different exchange rates and macro regimes, with some evolution in the composition of products in price indices. Taylor and Peel (2000) applied nonlinear methods to model a nominal exchange rate and monetary fundamentals (relative money supply and relative income), but such results are often sensitive to a small number of observations and become less robust as the sample evolves. Frömmel et al. (2005) estimated the real interest differential (RID) model of Frankel (1979) applying the Markov switching approach. However, the model was shown to relate to only one regime. Furthermore, the empirical failure of this model has been specifically found in regard of the US dollar–Japanese yen exchange rate. The evolution of this exchange rate …