Economic Modelling 25 (2008) 12161224

Contents lists available at ScienceDirect

Economic Modelling
j o u r n a l h o m e p a g e : w w w. e l s ev i e r. c o m / l o c a t e / e c o n b a s e

A structural time series test of the monetary model of exchange rates under four big inations
George B. Tawadros
School of Economics, Finance and Marketing, RMIT University, Building 108, Level 12, 239 Bourke St, Melbourne 3001, Australia

a r t i c l e

i n f o

a b s t r a c t
In this paper, the monetary model of exchange rate determination is tested using structural time series analysis under the Austrian, German, Hungarian and Polish hyperination episodes of the 1920s. The results obtained are highly supportive of this version of the monetary model, which explicitly allows for the phenomenon of currency substitution. They also show that the property of proportionality between the domestic money supply and the exchange rate cannot be rejected for Germany, Hungary and Poland. Furthermore, highly supportive evidence is found for the validity of the PPP relationship and the quantity theory of money, both of which are constituent components of the monetary model. 2008 Elsevier B.V. All rights reserved.

Article history: Accepted 3 April 2008 JEL classication: C12 C52 E31

Keywords: Hyperination The monetary model of exchange rates Structural time series modelling

1. Introduction Prior to the 1970s, the dominant paradigm in macroeconomics was the Keynesian school of thought. Keynesianism was used to model all aspects of the macroeconomy by academic economists, sparking a proliferation of macroeconomic models based on Keynesian principles. One such model that was developed to illustrate the mechanics of an open economy was the Mundell Fleming model.1 Embedded within this model was the process of exchange rate determination, which viewed the exchange rate as being determined by trade and capital ows. By the late 1970s, however, the analysis of exchange rates was entering a new phase. Critics of the MundellFleming model had argued that the process of exchange rate determination should be viewed not as an ongoing ow, but rather as a consequence of the effort to adjust asset stocks to the levels that economic agents desired. This new view on the process of exchange rate determination spawned the monetary model of exchange rates. It is considered to have been formally developed in the late 1970s in an attempt to explain the increased volatility and erratic nature of exchange rates faced by the major industrial nations after the collapse of the Bretton Woods system. The monetary model of exchange rate determination is an extension of domestic monetarism, stemming from the Chicago School, to the international economy in that it views the exchange rate as a monetary phenomenon [requiring] the tools of monetary theory and not barter or real trade theory (Johnson, 1977, p. 251). Its elements, however, go as far back as the early writings of John Wheatley, Henry Thornton, Gustav Cassel and even David Ricardo in the early 1800s. According to Johnson (1977, p. 265), erratic exchange rate movements are monetary symptoms of monetary disequilibria in domestic and foreign money markets. The monetary model looks at exchange rate adjustments as equilibrating the domestic and

The author would like to thank Graham N. Bornholt, Ashton J. de Silva, Mike J. Dempsey, Richard A. Heaney, Imad A. Moosa, Chris Panousis, Segu M. Zuhair, and two anonymous referees for their constructive comments and suggestions, that have helped improve the quality of an earlier draft. Any remaining errors are the responsibility of the author. Tel.: +61 3 9925 5510; fax: +61 3 9925 5986. E-mail address: George.Tawadros@rmit.edu.au. 1 See the classical work of Mundell (1962, 1963) and Fleming (1962). 0264-9993/$ see front matter 2008 Elsevier B.V. All rights reserved. doi:10.1016/j.econmod.2008.04.004

G.B. Tawadros / Economic Modelling 25 (2008) 12161224

1217

foreign markets for money. Factors impinging upon the supply and demand for domestic and foreign money will disturb equilibrium in money markets and will, therefore, inuence exchange rates. The popularity of the monetary model has generated considerable empirical work, with mixed results. The broad conclusion emerging from the extensive surveys conducted by Taylor (1995), MacDonald and Taylor (1992), Frankel and Rose (1995), Froot and Rogoff (1995), and Sarno and Taylor (2003), is that the monetary model performs rather poorly during tranquil periods, except in the very long run.2 In contrast, the model is found to have worked extremely well during periods of hyperination. For instance, Frenkel (1976) tests the monetary model using monthly data that span the German hyperination period, and obtains results that are fully supportive of the monetary model of exchange rates. Similarly, McNown and Wallace (1994) assert that a probable cause for the failure of the monetary model is that monetary factors have been inappropriately captured in tests for the industrialised nations. As such, they test the monetary model for three countries experiencing rapid monetary ination, and nd evidence that is highly supportive of the monetary model of exchange rates. The purpose of this paper is to shed more light on this issue by testing the monetary model of exchange rates under the Austrian, German, Hungarian, and Polish hyperination episodes of the 1920s. Like the study by Moosa (2000), this study is based on a different specication of the monetary model, as well as a different econometric technique. Studies by, inter alia, Frenkel (1976) and McNown and Wallace (1994), are based on either a dynamic bivariate model, relating the exchange rate to the domestic money supply, or on a dynamic cointegrating regression that explains the exchange rate in terms of the domestic money supply and the expected rate of ination. The use of such specications is justied on the grounds that under periods of hyperination, the effect of the domestic money supply dominates and overwhelms the effect of the other explanatory variables. The model used in this study differs from that used in the extant literature in a number of important ways. First, it incorporates an additional explanatory variable, that being the expected rate of change in the exchange rate, to allow for the possibility of currency substitution. This possibility is not allowed for in the canonical specications of the monetary model of exchange rates. Second, the effect of the other explanatory variables is not assumed to have been dominated and overwhelmed by the domestic money supply, but rather, is tested for. This is done using Harvey's (1989, 1990, 1993) structural time series model, where a stochastic trend for the exchange rate is specied that partly reects the effect of these variables, and whose importance can be inferred by the statistical signicance of the trend. This paper is organised as follows. In Section 2, the augmented monetary model of exchange rate determination is specied and the econometric methodology is briey presented. Section 3 provides a description of the data, while Section 4 presents the empirical results. In Section 5, some concluding remarks are provided. 2. Model specication Following Chrystal (1977), McKinnon (1982) and Moosa (1999, 2000), a variant of the monetary model of exchange rate determination is based on a money demand function that species the demand for real money balances as a function of domestic real income, a domestic nominal interest rate, and the expected change in the exchange rate. By invoking the money market equilibrium condition, where the demand for money is equal to the exogenously determined supply of money, we obtain the following relationship: mt pt a /yt kit bDse t1 1

where mt is the logarithm of the nominal supply of money, Pt is the logarithm of the domestic price level, yt is the logarithm of the e domestic real income, it is the domestic nominal interest rate, and st + 1 is the logarithm of the expected rate of change in the exchange rate at time t + 1, given that the expectation is made at time t. The exchange rate is measured as the number of domestic e currency units per one unit of the foreign currency, meaning that a positive value of st + 1 indicates an expected depreciation of the domestic currency, while a negative value indicates an expected appreciation of the domestic currency. The coefcient measures e the elasticity of currency substitution with respect to the change in the exchange rate, st + 1. A high value for this coefcient implies that a small expected depreciation of the domestic currency will lead to a signicant shift towards the foreign currency. Conversely, a small value for this coefcient implies that a small expected depreciation of the domestic currency will lead to a small shift towards the foreign currency. The purchasing power parity (PPP) condition is given by: st pt p t 2

where p is the logarithm of the foreign price level. By substituting Eq. (1) into Eq. (2), and rearranging, we obtain the following t equation:   st mt bDse a p4 /yt kit 3 t t1 Eq. (3) shows that there is an equal and proportionate relationship between the exchange rate and the domestic money supply, so that any rise in the domestic money supply will lead to an equal and proportionate depreciation of the domestic currency. It also shows that there is a positive relationship between the current level of the exchange rate and the expected change in the exchange rate prevailing in the next period, such that the greater is the expected appreciation of the domestic currency, the higher will its
2 See, inter alia, Kearney and MacDonald (1990), MacDonald and Taylor (1991), Baillie and Pecchenino (1991), Van den Berg and Jayanetti (1993), Moosa (1994), McNown and Wallace (1994), Dibooglu and Enders (1995), Chrystal and MacDonald (1995), and Tawadros (2001).

1218

G.B. Tawadros / Economic Modelling 25 (2008) 12161224

current value be. Conversely, the greater is the expected depreciation of the domestic currency, the lower will be its current value. This reects the process of destabilising speculation, under which a weak currency is expected to be even weaker in the future, and so traders sell it, leading to its depreciation. The opposite is also true, whereby a strong currency is expected to be even stronger in the future, and so traders buy it, leading to its appreciation. Following Moosa (1999, 2000), a number of modications are introduced to Eq. (3). First, the effect of foreign prices, domestic real income and interest rates, is assumed to be incorporated in the behaviour of a stochastic trend, t, so that t = ( + p t + /yt kit). This assumption is justied on the basis that, while these variables may be individually dominated and overwhelmed by monetary changes, they may still exert some effect on the exchange rate collectively, as indicated by a signicant t. Second, the assumption of proportionality between the exchange rate and the domestic money supply is relaxed, so that it can be tested for, and nally, a random component, t, is included in the model. As such, the model becomes: st At gmt bDse et t1 4

Eq. (4) shows that the exchange rate is determined by two unobservable components, these being the trend, t, and the random e component, t, as well as the explanatory variables mt and st + 1. The trend component represents the long-term movement of the exchange rate, and is assumed to be stochastic and linear. This component can be represented by the following equations: At At1 bt1 gt bt bt1 ft 5 6

2 2 where t ~ NID (0, ), and t ~ NID (0, ). The trend component, t, is a random walk with a drift factor, t, which follows a rst-order 2 autoregressive process represented by Eq. (6). This process collapses to a simple random walk with drift if = 0, and to a deterministic 3 2 2 2 linear trend if = 0 as well. If, on the other hand, = 0 while 0, the process will have a trend that changes relatively smoothly. 2 2 The variances and , as well as the components and the coefcients on the explanatory variables, can be estimated by maximum likelihood using the Kalman lter to update the state vector. This procedure requires writing the model in state space form. Related smoothing algorithms can be used to obtain the estimates of the state vector at any point in time within the sample period.4 According to, inter alia, Frenkel (1976) and Johnson (1977), the role played by expectations in determining the exchange rate is a natural implication of the asset approach to the determination of exchange rates. Since the demand for money depends on the expected rate of return, the current value of the exchange rate must be inuenced by the expectations that market participants have about the future value of the exchange rate. There is sufcient evidence to suggest that under episodes of hyperination, expectations are predominantly adaptive or extrapolative.5 As such, extrapolative expectations are dened as:

Dse uDst t1 where N 0. Substituting Eq. (7) into Eq. (4) yields the following specication for the monetary model: st At gmt hDst et

where = . As it stands, Eq. (8) does not lend itself to the use of cointegration analysis. This is because under an episode of hyperination, it is expected that st ~ I(2), mt ~ I(2), pt ~ I(2), and st ~ I(1), so that Eq. (8) cannot represent a cointegrating relationship in the strictest sense. However, the specication of Eq. (8) is based on economic theory, in which case it would be incorrect to re-specify Eq. (8) so that it is amenable to cointegration analysis. The use of Harvey's (1989, 1990, 1993) structural time series model solves this issue. The rationale behind Eq. (8) is intuitive. The dependent variable, st, is explained by its trend and random components, as well as the explanatory variables mt and st. The variable mt explains the long-term movements of st, because both are integrated of order 2, while st explains the short-run variations in st, which would otherwise be reected in the random component, t. Harvey (1989, 1990, 1993) shows that if mt does not explain the long-term movements in st completely, then the stochastic trend, t, will be statistically signicant, suggesting that the variables which do not explicitly appear in Eq. (8) play an important but indirect role. He suggests that a stochastic trend is needed when the orders of integration of the variables are not the same. In particular, if the model is correctly specied, then the order of integration of the dependent variable cannot be less than the order of integration of any explanatory variable. On the other hand, Harvey (1989, 1990, 1993) shows that if the order of integration of the dependent variable is greater than that of each of the explanatory variables, then a stochastic trend must be present. 3. The data The empirical results reported in this paper are based on a sample of monthly observations for Austria, Germany, Hungary and Poland, all of which suffered protracted episodes of hyperination during the 1920s. The sample period differs for each country. For
3 Harvey (1989, 1990, 1993) shows that testing for a unit root is related to testing for a deterministic linear trend in his model. In Harvey's (1989, 1990, 1993) 2 2 model, the null hypothesis of = 0 is tested against the alternative that N 0, implying that under the null hypothesis, there is a deterministic linear trend. In cointegration analysis, the null hypothesis tested is that a variable or residual contains a stochastic trend, whereas the alternative is stationary. See Harvey (1989, 1990, 1993) for more details. 4 2 For more details relating to the estimation of and 2 using the Kalman lter, see Harvey (1989, 1990, 1993) and Koopman et al. (2000). 5 See, inter alia, Cagan (1956), Barro (1970), Frenkel (1977, 1979), Abel et al. (1979), Taylor (1991), and Pilbeam (1995).

G.B. Tawadros / Economic Modelling 25 (2008) 12161224

1219

Fig. 1. The supply of money (logarithmic scale).

Austria, the data span the period January 1921 to June 1924, while for Germany, it covers the period January 1921 to December 1924. The sample period for Hungary spans the period July 1921 to March 1925, while for Poland, it encompasses the period January 1921 to April 1924. For all four countries, money is measured by the amount of notes in circulation. Prices are measured by the retail price index for Austria and Hungary, while for Germany and Poland, they are measured by the wholesale price index.6 The exchange rates are measured as the Austrian crown vis--vis the US dollar, the German mark vis--vis the US dollar, the Hungarian krone vis--vis the US dollar, and the Polish mark vis--vis the US dollar. All of the data series were obtained from Young (1925) and Sargent (1982).7 Fig. 1 shows the supply of money in each country, while Fig. 2 shows the level of prices. Similarly, Fig. 3 shows the exchange rate for each country. All three gures suggest that all of the variables appear to be integrated of order 2. The gures also highlight the proposition that each country's money supply and price level can explain the long-term movements in the exchange rate. Furthermore, the gures provide strong evidence for the positive relationships between the domestic money supply and the price level (as postulated by the quantity theory of money), the domestic price level and the exchange rate (as posited by the PPP relationship), and the domestic money supply and the exchange rate (as postulated by the monetary model of exchange rate determination). It is important to recall that the monetary model is obtained by combining the PPP relationship with the quantity theory of money. 4. Empirical results Table 1 presents the results of testing for a unit root in the variables entering Eq. (8), using the Elliot et al. (1996) DFGLS test, and GLS GLS the Ng-Perron (2001) MZ , MZ , MSBGLS, and MPGLS tests. The results show that st ~ I(2), mt ~ I(2), pt ~ I(2) and st ~ I(1). This T suggests that Eq. (8) satises the requirement that the order of integration of the dependent variable is not less than the order of integration of any of the explanatory variables, indicating that the model is correctly specied. Table 2 reports the maximum likelihood estimates of the quantity theory of money, the PPP relationship, and the exible price monetary model of exchange rates for Austria.8 The table reports the nal state vector, which includes the components t and t, as well as the coefcients on the respective explanatory variables, together with their standard errors in parenthesis. The table ~ also presents a variety of goodness of t measures and diagnostic tests. The goodness of t is measured by the standard error, , 2 ~ is the standard error of the estimated equation, calculated as and the modied coefcient of determination, Rd . The measure of 2 the square root of the one-step ahead prediction error variance. The statistic Rd is the coefcient of determination calculated on the basis of the prediction error variance, which is more appropriate for data that exhibits trend movements than the conventional R2. The diagnostic tests include the DurbinWatson statistic, DW, the autocorrelation coefcients of the residuals at lags 1, r(1), and 8, r(8), and the Ljung-Box (1978) Q(P, d) statistic based on the rst P residual autocorrelations, and is approximately distributed as 2 d , and the Doornik and Hansen (1994) N(d) statistic for normality based on the third and fourth moments of the distribution,

6 7 8

The measure of prices used is limited by the availability of an appropriate price index. For more details on these four big inations, see Meiselman (1970) and Sargent (1982). The estimations in this study were carried out using the software developed by Koopman et al. (2000).

1220

G.B. Tawadros / Economic Modelling 25 (2008) 12161224

Fig. 2. The level of prices (logarithmic scale).

2 which is approximately distributed as 2 under the null hypothesis. The last diagnostic test statistic reported is the simple nonparametric H(h) test used to detect the presence of heteroscedasticity. It is calculated as the ratio of the squares of the last h residuals to the squares of the rst h residuals, where h is the closest integer to one-third of the sample size, and is approximately distributed as F(h, h). The results show that the quantity theory of money, the PPP relationship and the monetary model are reasonably well determined. Each equation passes the test for serial correlation and heteroscedasticity, but fails the test for normality. The coefcients on the explanatory variables are statistically signicant and correctly signed for the quantity theory and PPP relationship. However, the Austrian money supply is insignicant in the equation describing the monetary model of exchange rates. The component t is signicant for the quantity theory and PPP relationship, suggesting that while monetary changes were dominant in these two equations, other factors had a collective inuence on the determination of the dependent variable. However, this component is insignicant for the monetary model. In the equation describing the exible price monetary model of exchange rates, the highly signicant coefcient on st highlights the importance of currency substitution during periods of hyperination, because the Austrian crown fails to perform the functions of money, particularly that of being a store of value and a unit of account. The hypothesis of proportionality cannot be

Fig. 3. The level of exchange rates (logarithmic scale).

G.B. Tawadros / Economic Modelling 25 (2008) 12161224 Table 1 The results of testing for unit roots DFGLS Austria st mt pt st mt pt 2st 2mt 2pt Germany st mt pt st mt pt 2st 2mt 2pt Hungary st mt pt st mt pt 2st 2mt 2pt Poland st mt pt st mt pt 2st 2mt 2pt 1.135 1.887 1.743 1.268 1.814 1.905 3.954 4.015 3.688 MZGLS 3.489 2.827 6.889 8.930 9.972 13.320 30.821 20.327 19.854 MZGLS 1.160 0.979 1.723 2.113 2.230 2.580 3.926 3.186 3.151 MSBGLS 0.332 0.346 0.250 0.237 0.224 0.194 0.127 0.157 0.159

1221

MPGLS T 23.379 26.419 13.356 10.205 9.153 6.843 2.957 4.492 4.590

1.725 2.277 1.808 2.469 2.575 2.516 3.665 6.255 3.545

5.746 10.373 6.354 16.419 10.705 15.669 21.937 23.463 35.353

1.687 2.273 1.782 2.862 2.288 2.779 3.312 3.425 4.204

0.294 0.219 0.280 0.174 0.214 0.177 0.151 0.146 0.119

15.844 8.806 14.342 5.571 8.638 5.933 4.154 3.884 2.579

1.671 2.569 1.585 1.909 2.784 2.477 4.350 5.229 4.673

10.559 13.711 6.296 16.331 16.865 14.065 46.384 201.572 84.919

2.144 2.593 1.602 2.855 2.869 2.635 4.816 10.029 6.516

0.203 0.189 0.255 0.175 0.170 0.187 0.104 0.050 0.077

9.347 6.792 14.419 5.597 5.610 6.578 1.965 0.479 1.074

1.789 0.128 1.764 2.897 1.529 3.024 3.622 3.965 7.288

0.905 13.848 6.274 16.752 5.874 13.104 31.004 27.093 18.872

0.484 2.498 1.665 2.824 1.445 2.462 3.937 3.657 3.072

0.534 0.180 0.265 0.169 0.246 0.188 0.127 0.135 0.163

58.831 7.326 14.479 5.857 15.114 7.490 2.941 3.500 4.829

Notes: The order of augmentation is based on the minimisation of the modied Akaike Information Criterion, the modied Schwartz Information Criterion, and the modied HannanQuinn criterion. The 5% critical values are 3.190 for the DFGLS test, 17.300 for the MZGLS test, 2.910 for the MZGLS test, 0.168 for the MSBGLS test, and 5.480 for the MPGLS test. An asterisk denotes a rejection of the null hypothesis. T

rejected for the quantity theory of money, with the t-statistic for the null of a unitary coefcient on the money supply being 1.850. For the PPP relationship, however, this hypothesis is (marginally) rejected, with the t-statistic for the coefcient on pt being 2.040. The maximum likelihood estimates of the quantity theory of money, the PPP relationship and the exible price monetary model of exchange rates for Germany, are presented in Table 3. A variety of diagnostic tests and goodness of t measures are also reported. Like the results obtained for Austria, all three equations are reasonably well determined, with each equation passing the test for serial correlation and heteroscedasticity, but failing the test for normality. However, each equation passes only the test for serial correlation. The coefcients on the explanatory variables are signicant and correctly signed in each equation. The trend component, t, is signicant for each equation, suggesting that other factors played some role in the determination of the dependent variable, even though monetary changes dominated.9 For the exible price monetary model, the highly signicant coefcient on st highlights the importance of currency substitution, although the magnitude of this coefcient is somewhat smaller than that obtained for Austria. Like the results obtained by Cagan (1956) and Frenkel (1977) for Germany, the hypothesis of proportionality cannot be rejected, with the t-statistic being

9 For instance, Young (1925) and Sargent (1982) show that the German mark depreciated more rapidly during 1923 than in previous years because of the collapse in output. Before 1923, the growth in output was a retarding force against rapid ination and currency depreciation.

1222 Table 2 Estimation results for Austria State variable/test statistic t t mt pt st ~ R2 d DW r(1) r(8) Q(8, 6) N(2) H(13)

G.B. Tawadros / Economic Modelling 25 (2008) 12161224

Quantity theory 18.287 (3.023) 0.032 (0.031) 1.246 (0.133)

PPP 4.659 (1.762) 0.279 (0.043)

Monetary model 0.067 (5.847) 0.014 (0.150) 0.493 (0.257)

0.645 (0.174) 0.539 (0.049) 0.142 0.720 1.564 0.214 0.066 12.055 11.532 0.037

0.113 0.707 1.726 0.133 0.256 8.103 8.166 0.514

0.227 0.265 2.075 0.044 0.046 12.522 30.965 0.023

Notes: An asterisk denotes signicance at the 5% level.

1.769 for the null that the coefcient on the money supply in the quantity theory of money is unity. Proportionality also holds in the PPP relationship and the exible price monetary model, as the results in Table 3 show. The t-statistics for the null hypothesis of unit coefcients on pt in the PPP relationship and mt in the exible price monetary model are 0.072 and 0.504, respectively, both of which are insignicant. Table 4 reports the corresponding results for Hungary. They show that all three equations are reasonably well determined, with each model passing the diagnostic tests for serial correlation, normality and heteroscedasticity. The coefcients on the explanatory variables are statistically signicant and correctly signed, with the trend component being insignicant for only the quantity theory of money. The hypothesis of proportionality cannot be rejected for the quantity theory of money and the exible price monetary model, but is (marginally) rejected for the PPP relationship, with the t-statistic for the coefcient on pt being 2.078. In Table 5, the maximum likelihood estimates for Poland are presented. Like the results obtained for Hungary, all three equations pass the diagnostic tests. The coefcients on the explanatory variables are all signicant and correctly signed, with the coefcient on st being the largest in magnitude across all four European countries. This suggests that the phenomenon of currency substitution was more pervasive for the Polish mark than for any other currency, as domestic residents used the US dollar instead of the Polish mark as a medium of exchange, unit of account and a store of value. The hypothesis of proportionality cannot

Table 3 Estimation results for Germany State variable/test statistic t t mt pt st ~ R2 d DW r(1) r(8) Q(8, 6) N(2) H(15) Notes: An asterisk denotes signicance at the 5% level. 0.262 0.949 2.120 0.064 0.038 6.782 12.030 1.513 1.112 0.539 2.000 0.015 0.067 7.254 140.560 0.471 Quantity theory 4.019 (0.759) 0.090 (0.069) 1.046 (0.026) PPP 8.316 (3.189) 0.197 (0.194) Monetary model 8.895 (3.641) 0.152 (0.202) 0.935 (0.129)

1.009 (0.123) 0.347 (0.073) 0.901 0.703 1.849 0.063 0.060 11.555 32.912 0.811

G.B. Tawadros / Economic Modelling 25 (2008) 12161224 Table 4 Estimation results for Hungary State variable/test statistic t t mt pt st ~ R2 d DW r(1) R(8) Q(8, 6) N(2) H(14) Notes: An asterisk denotes signicance at the 5% level. 0.139 0.347 1.434 0.281 0.017 10.179 3.368 0.633 0.150 0.410 2.016 0.034 0.131 4.333 3.322 1.905 Quantity theory 3.525 (2.987) 0.019 (0.060) 0.723 (0.196) PPP 4.099 (1.885) 0.020 (0.028)

1223

Monetary model 8.625 (2.967) 0.008 (0.099) 0.995 (0.194)

0.732 (0.129) 0.498 (0.039) 0.095 0.763 1.906 0.034 0.124 8.697 3.591 0.794

be rejected for the quantity theory of money, the PPP relationship, and the exible price monetary model, as stipulated by the theoretical specications of monetarist specications. 5. Conclusions In this paper, the monetary model of exchange rate determination is tested using structural time series analysis under the Austrian, German, Hungarian and Polish hyperination episodes of the 1920s. The results obtained are highly supportive of this version of the monetary model, which explicitly allows for the phenomenon of currency substitution. They show that the domestic money supply and the expected rate of change in the exchange rate played a dominant role in determining all four exchange rates against the US dollar. Furthermore, the empirical evidence is highly supportive of the property of proportionality, as stipulated by the theoretical specications of the monetarist propositions, between the exchange rate and the money supply for Germany, Hungary and Poland. Moreover, the hypothesis of proportionality between prices and the money supply in the quantity theory of money cannot be rejected for any country. However, this property is (marginally) rejected for Austria and Hungary in the PPP relationship. These results highlight the importance of the prevailing economic conditions, under which the monetary model of exchange rate determination is tested. As stated previously, the monetary model performs rather poorly during tranquil periods, where there are no bouts of hyperination, except in the very long run. In contrast, the model works extremely well during periods of hyperination, when the domestic money supply dominates and overwhelms the effect of other factors, at home and abroad.
Table 5 Estimation results for Poland State variable/test statistic t t mt pt st ~ R2 d DW r(1) R(8) Q(8, 6) N(2) H(12) Notes: An asterisk denotes signicance at the 5% level. 0.197 0.523 1.378 0.300 0.027 10.793 2.651 0.207 0.136 0.795 1.803 0.093 0.000 5.899 3.962 0.230 Quantity theory 2.170 (3.133) 0.023 (0.087) 0.850 (0.155) PPP 6.692 (1.526) 0.022 (0.029) Monetary model 6.497 (2.100) 0.035 (0.035) 0.887 (0.104)

0.936 (0.079) 0.567 (0.078) 0.145 0.771 1.212 0.381 0.060 12.213 0.332 0.548

1224

G.B. Tawadros / Economic Modelling 25 (2008) 12161224

References
Abel, A., Dornbusch, R., Huizinga, J., Marcus, A., 1979. Money demand during hyperination?. Journal of Monetary Economics 5 (1), 97104. Baillie, R.T., Pecchenino, R.A., 1991. The search for equilibrium relationships in international nance: the case of the monetary model. Journal of International Money and Finance 10 (4), 582593. Barro, R.J., 1970. Ination, the payments period and the demand for money. Journal of Political Economy 78 (6), 12281263. Cagan, P., 1956. The monetary dynamics of hyperination. In: Friedman, M. (Ed.), Studies in the Quantity Theory of Money. University of Chicago Press, Chicago, pp. 25117. Chrystal, A.K., 1977. Demand for International Media of Exchange. American Economic Review 67 (5), 840850. Chrystal, A.K., MacDonald, R., 1995. Exchange rates, nancial innovation and divisia money: the Sterling/dollar rate, 19721990. Journal of International Money and Finance 14 (4), 493513. Dibooglu, S., Enders, W., 1995. Multiple cointegrating vectors and structural economic models: an application to the French franc/US dollar exchange rate. Southern Economic Journal 61 (4), 10981116. Doornik, J.A., Hansen, H., 1994. An Omnibus Test for Univariate and Multivariate Normality. Nufeld College Working Paper No. W4&91. University of Oxford, Oxford. Elliot, G., Rothenberg, T.J., Stock, J.H., 1996. Efcient tests for an autoregressive unit root. Econometrica 64 (4), 813836. Fleming, M.J., 1962. Domestic nancial policies under xed and oating exchange rates. IMF Staff Papers 9 (1), 369380. Frankel, J.A., Rose, A.K., 1995. Empirical research on nominal exchange rates. In: Grossman, G.M., Rogoff, K. (Eds.), Handbook of International Economics, vol. 3. North Holland, Amsterdam, pp. 16891729. Frenkel, J.A., 1976. A monetary approach to the exchange rate: doctrinal aspects and empirical evidence. Scandinavian Journal of Economics 78 (2), 200224. Frenkel, J.A., 1977. The forward exchange rate, expectations and the demand for money: the German hyperination. American Economic Review 67 (4), 653670. Frenkel, J.A., 1979. Further evidence on expectations and the demand for money during the german hyperination. Journal of Monetary Economics 5 (1), 8196. Froot, K.A., Rogoff, K., 1995. Perspectives on PPP and long-run real exchange rates. In: Grossman, G.M., Rogoff, K. (Eds.), Handbook of International Economics, vol. 3. North Holland, Amsterdam, pp. 16471688. Harvey, A.C., 1989. Forecasting, Structural Time Series Models and the Kalman Filter. Cambridge University Press, Cambridge. Harvey, A.C., 1990. The Econometric Analysis of Time Series Models, 2nd edn. Philip Allen Press, New York. Harvey, A.C., 1993. Time Series Models, 2nd edn. Harvester Wheatsheaf Press, Hempstead. Johnson, H.G., 1977. The monetary approach to the balance of payments: a nontechnical guide. Journal of International Economics 7 (3), 251268. Kearney, C., MacDonald, R., 1990. Rational expectations, bubbles and monetary models of the exchange rate: the Australian/US dollar rate during the recent oat. Australian Economic Papers 29 (54), 120. Koopman, S.J., Harvey, A.C., Doornik, J.A., Shephard, N., 2000. STAMP 6.30: Structural Time Series Analyser, Modeller and Predictor. Timberlake Consultants Press, London. Ljung, G.M., Box, G.E.P., 1978. On a measure of lack of t in time series models. Biometrika 65 (2), 297303. MacDonald, R., Taylor, M.P., 1991. The monetary approach to the exchange rate: long-run relationships and coefcient restrictions. Economics Letters 37 (2), 179185. MacDonald, R., Taylor, M.P., 1992. Exchange rate economics: a survey. IMF Staff Papers 39 (1), 157. McKinnon, R.I., 1982. Currency Substitution and Instability in the World Dollar Standard. American Economic Review 72 (3), 320333. McNown, R., Wallace, M.S., 1994. Cointegration tests of the monetary exchange rate model for three high-ination economies. Journal of Money, Credit and Banking 26 (3), 396411. Meiselman, D., 1970. The Varieties of Monetary Experience. University of Chicago Press, Chicago. Moosa, I.A., 1994. The monetary model of exchange rates revisited. Applied Financial Economics 4 (4), 279287. Moosa, I.A., 1999. Testing the currency substitution model under the German hyperination. Journal of Economics 70 (1), 6178. Moosa, I.A., 2000. A structural time series test of the monetary model of exchange rate determination under the German hyperination. Journal of International Financial Markets, Institutions and Money 10 (2), 213223. Mundell, R.A., 1962. The appropriate use of monetary and scal policy for internal and external stability. IMF Staff Papers 9 (1), 7079. Mundell, R.A., 1963. Capital mobility and stabilisation policy under xed and exible exchange rates. Canadian Journal of Economics and Political Science 29 (4), 475485. Ng, S., Perron, P., 2001. Lag length selection and the construction of unit root tests with good size and power. Econometrica 69 (6), 15191554. Pilbeam, K., 1995. Exchange rate models and exchange rate expectations: an empirical investigation. Applied Economics 27 (11), 10091015. Sargent, T.J., 1982. The ends of four big inations. In: Hall, R.H. (Ed.), Ination Causes and Effects. Chicago University Press, Chicago, pp. 4197. Sarno, L., Taylor, M.P., 2003. The Economics of Exchange Rates. Cambridge University Press, Cambridge. Tawadros, G.B., 2001. The predictive power of the monetary model of exchange rate determination. Applied Financial Economics 11 (3), 279286. Taylor, M.P., 1991. The hyperination model of money demand revisited. Journal of Money, Credit and Banking 23 (3), 327351. Taylor, M.P., 1995. The economics of exchange rates. Journal of Economic Literature 33 (1), 1347. Van den Berg, H., Jayanetti, S.C., 1993. A novel test of the monetary approach using black market exchange rates and the JohansenJuselius cointegration method. Economics Letters 41 (3), 413418. Young, J.P., 1925. European Currency and Finance, Commission of Gold and Silver Inquiry, US Senate, serial 9, vol. 2. US Government Printing Ofce, Washington DC.