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The dollar–euro exchange rate and monetary fundamentals

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Abstract

This study analyzes the relationship between the dollar–euro exchange rate and macroeconomic fundamentals according to the monetary model after 1999. Multivariate and time-varying univariate cointegration techniques are used to test for a long-run equilibrium and changes in the underlying coefficients. Our results provide clear evidence of a long-run relationship between exchange rates and fundamentals. However, we find significant changes in the economic impact of fundamentals on the dollar–euro exchange rate. Both long-run and the short-run coefficients are shown to be strongly time-varying and significantly affected by the financial crisis and the emergence of unconventional monetary policy.

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Notes

  1. See, for example, Sarno and Taylor (2002) for a discussion of such models.

  2. The imperfect knowledge approach is based on the idea that market participants do not know the exact model but use fundamentals to forecast exchange rates in a way consistent with assumed theory. Accordingly, the link between fundamentals and the exchange rate changes when market participants revise their belief in the underlying model.

  3. According to their findings, the EU model outperforms the DM model, since the latter is not able to beat a random walk forecast significantly at any forecast horizon.

  4. If Eq. (3) is combined with uncovered interest rate parity (UIP) and the expected change in the exchange rate is considered stationary, the nominal exchange rate is driven only by relative money and income, that is, by money velocity.

  5. Frenkel (1976) analyzed the monetary model for the period of German hyperinflation in the 1920s.

  6. Further shortcomings include a possible endogeneity bias, since the choice of the nominal exchange rate as the left-hand variable is arbitrary, see Sarno and Taylor (2002).

  7. For example, the results of suggest that an increase in German money supply results in an appreciation of the mark. In addition, several explanations for the rise of the dollar during the early eighties have been raised in the literature.

  8. Estimations with alternative configurations leave our main results unchanged and are available upon request.

  9. Since excess kurtosis does not introduce a significant bias to the estimated cointegration vectors, the findings are more sensitive to excess skewness (Juselius 2006).

  10. Both adjustment coefficients and recursive estimations are available upon request.

  11. The OLS estimator is superconsistent in case of cointegration.

  12. As a robustness check, we have also carried out recursive maximum likelihood estimations of the cointegrating vectors in the multivariate framework. The results, which are available upon request, show a related pattern of higher volatility compared to the estimates reported in the next section.

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Authors and Affiliations

  1. Kiel Institute for the World Economy, University of Bochum, GC 3/145 Universitätsstraße 150, 44801, Bochum, Germany

    Joscha Beckmann

  2. City University London, Northampton Square, London, EC1V 0ES, UK

    Dionysius Glycopantis & Keith Pilbeam

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  1. Joscha Beckmann
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  2. Dionysius Glycopantis
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Correspondence to Joscha Beckmann.

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Beckmann, J., Glycopantis, D. & Pilbeam, K. The dollar–euro exchange rate and monetary fundamentals. Empir Econ 54, 1389–1410 (2018). https://doi.org/10.1007/s00181-017-1335-1

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