Abstract

The Monetary Approach to Exchange Rates: A Review of Recent Empirical Studies

There has been tremendous interest over the past decade in the monetary approach to the balance of payments and exchange rates. Since the adoption of flexible exchange rates, a number of empirical studies of the monetary approach to exchange rates have been undertaken. Most of the first generation of the studies reported results favorable to the monetary approach with its “new” hypothesis that high interest rates would be associated with weak rather than strong currencies, and more rapid economic growth would be associated with appreciation rather than depreciation. Later research provides much less support, however. This paper critically reviews the published empirical studies applying the monetary approach and presents new empirical evidence. We conclude that while the simple monetary approach model fits the data quite well for some countries over some times periods, these relationships do not hold up systematically across countries and over time. In addition to a number of technical issues of econometric estimation and model specifications, we emphasize the need to distinquish between short-run and longer-run applications of the monetary approach. As with domestic macro models, the monetary exchange rate models appear to have a great deal of explanatory power with respect to longer-run trends, but the operation of real factors substantially reduces their explanatory power for short-run analysis.