The Failure of the Monetary Model of Exchange Rate Determination
31 Pages Posted: 7 Apr 2015
Date Written: March 2015
In this paper, we test three popular versions of the monetary model (flexible price, forward-looking and real interest differential models) for the OECD member countries by applying Johansen cointegration technique. Based on country-by-country analysis, we conclude that monetary models do not provide the expected results. We reveal several shortcomings of the models and examine the building blocks of the fundamental version. Although researchers always blame the deviations from purchasing power parity as the reason for the failure of the monetary model, our analysis indicates that invalidity of Keynesian money demand function is also responsible for unfavourable results.
Keywords: exchange rate, flexible price monetary model, forward-looking monetary model, real interest differential model, money demand, purchasing power parity
JEL Classification: F31, F41
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