Exchange rate models: Do they work?

Conclusions In this paper we have examined empirically five asset-market exchange rate models: the flexible-price monetary model, the sticky-price model, the Hooper-Morton model, the stock-flow model and the portfolio balance model. Each of these models was estimated for the Deutsche mark/dollar exchange rate over the floating period. The empirical results suggest that none of the models is fully supported by the data. Our findings are similar to those of other studies [see, e.g., Backus, 1984; Boughton, 1985; Frankel, 1983; Meese, Rogoff, 1983]. The failure of various exchange rate models to explain the behaviour of the Deutsche mark/dollar exchange rate may be attributed to a number of factors, such as the instability of money demand functions observed in the U.S. and Germany in the mid-1970s¹¹, the intervention of the Bundesbank in an effort to mitigate the large fluctuations of the Deutsche mark/dollar exchange rate, and speculation, which may be increasingly important. This suggests that further theoretical and empirical work is required to resolve the issue of how best to model the exchange rate determination.