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"Dumb And Dumber" Explanations For Exchange Rate Dynamics

The failure of the structural monetary model to beat a random walk in out-of-sample forecasting is one of the most celebrated empirical (non) findings in international finance. In this paper we show that this result is an artifact of the way monetary policy is measured. We construct a simple measure of monetary policy based on the narrative approach of Romer & Romer (1989). Using a linear Gaussian autoregressive specification with exogenous variables (ARX), we demonstrate that a structural monetary model with properly measured money does indeed outperform the random walk in out-of-sample forecasts over a wide range of horizons. We conclude that contrary to the conventional wisdom, money (appropriately defined) is a robust fundamental determinant of short-run exchange rate dynamics.

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Article provided by Universidad del CEMA in its journal Journal of Applied Economics.

Volume (Year): 4 (2001)
Issue (Month): (November)
Pages: 187-216

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Handle: RePEc:cem:jaecon:v:4:y:2001:n:2:p:187-216
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  2. Ben S. Bernanke & Ilian Mihov, 1995. "Measuring Monetary Policy," NBER Working Papers 5145, National Bureau of Economic Research, Inc.
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  8. Richard Meese & Andrew K. Rose, 1989. "An empirical assessment of non-linearities in models of exchange rate determination," International Finance Discussion Papers 367, Board of Governors of the Federal Reserve System (U.S.).
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  18. Chinn, Menzie D. & Meese, Richard A., 1995. "Banking on currency forecasts: How predictable is change in money?," Journal of International Economics, Elsevier, vol. 38(1-2), pages 161-178, February.
  19. Martin Eichenbaum & Charles L. Evans, 1995. "Some Empirical Evidence on the Effects of Shocks to Monetary Policy on Exchange Rates," The Quarterly Journal of Economics, Oxford University Press, vol. 110(4), pages 975-1009.
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