“Dumb and Dumber” Explanations for Exchange Rate Dynamics

Abstract

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.

JEL classification codes:

• F31
• G12

Key words:

• exchange rates
• asset prices
• monetary policy