The Monetary Approach to the Exchange Rate: Rational Expectations, Long-Run Equilibrium, and Forecasting

We reexamine the monetary approach to the exchange rate from several perspectives, using monthly data on the deutsche mark-U.S. dollar exchange rate. Using the Campbell-Shiller technique, we reject the restrictions imposed on the data by the forward-looking rational expectations monetary model. The monetary model, however, is validated as a long-run equilibrium condition. Moreover, imposing the long-run monetary model restrictions in a dynamic error-correction framework leads to exchange rate forecasts that are superior to those generated by a random walk forecasting model.