The Monetary Model of the Exchange Rate

Abstract

We emphasize the importance of properly identifying the long-run relations underlying the monetary model of the exchange rate. The separate estimation of long-run money demands leads to a “structural” error correction equation which allows an interpretation of the various channels affecting the exchange rate in the monetary model. We apply this approach to the analysis of the DM/Dollar exchange rate where the structural model yields better results than various alternative forecast strategies, among them a random walk.