A short-run monetary model of exchange rate determination: Stability tests and forecasting

The paper develops a short-run econometric monetary model of exchange rate determination. The model assumes a conventional money demand function, markets which are linked by interest arbitrage, adaptive expectations formation, and parameters which are stable over time. One-period-ahead forecasts of the mark/pound rate generated by the model compare favorably with naive model forecasts using monthly data. Stability tests provided evidence of parameter instability in 1976 but correction for it did not improve forecasting accuracy. The inability of monetary models to forecast accurately may be due to the underlying model assumptions rather than parameter instability.