The observed vs. implied dollar movements: a 1973-1990 case study

This paper studies the observed behavior of the U.S. dollar within the theoretical scope of the exchange rate models as defined under the title of “asset market” view. The monetary approach and portfolio-balance approach models are tested over the sample period as well as shorter time episodes. The objectiveis to validate the exchange rate theories, and to identify episodes during which the observed dollar behaviors were consistent with those implied by the exchange rate models. The study finds many episodes during which the observed dollar behavior was matched with the implied dollar movements derived from testing the exchange rate models. In addition, the empirical evidence seems to be more supportive of the monetary approach’s flexible-price exchange rate model. However, the instability of the estimated coefficients in terms of both coefficient signs and statistical significance remains a serious problem, which can be attributed to misspecification of variables and failure of models to fully capture economic events.