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Ms. Ellen Marie Nedde

Abstract

Conventional models of the U.S. current account, which express trade flows as functions of activity variables and relative prices, have recently been criticized on the grounds that they fail to reflect fully supply-side effects and, as a result, generate medium-term projections that may be overly pessimistic. These criticisms were partly fueled by the inability of many modelers to forecast accurately the turning point in U.S. trade and current account developments since 1987 and the degree of more recent improvements.1

Mr. Ronald MacDonald and Mr. Mark P. Taylor

exchange rate has some validity when considered as a long-run equilibrium condition; second, that when the exchange rate fundamentals suggested by the monetary model are assumed, the speculative bubbles hypothesis is rejected; and third, that the full set of rational expectations restrictions imposed by the forward-looking monetary model are rejected. Finally, however, we demonstrate that the monetary model can be used to generate a dynamic error-correction exchange rate equation that has robust in-sample and out-of-sample properties—including beating a random walk

Mr. Ronald MacDonald and Mr. Mark P. Taylor
We re-examine the monetary approach to the exchange rate from a number of perspectives, using monthly data on the deutschemark-dollar exchange rate. Using the Campbell-Shiller technique for testing present value models, we reject the restrictions imposed upon the data by the forward-looking rational expectations monetary model. We demonstrate, however, that the monetary model 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 which are superior to those generated by a random walk forecasting model.