Does the Euro follow the German Mark? Evidence from the monetary model of the exchange rate

This paper investigates whether German or synthetic European pre-EMU data provides the appropriate empirical basis for evaluating Euro/Dollar exchange rate behavior. Monetary exchange rate equations are estimated for both data sets over the pre-EMU period, and out-of-sample forecasts are evaluated to assess their ability to explain the Euro/Dollar exchange rate from 1999 to 2004. While forecast accuracy tests confirm the usefulness of synthetic European data for Euro exchange rate analysis, forecasts based on the German pre-EMU experience cannot even beat a random walk. Our results indicate that the Euro does not simply follow the German Mark, but that it has its origins in the other pre-EMU currencies as well.