Do Forecasters use Monetary Models? An Empirical Analysis of Exchange Rate Expectations

Do financial market analysts use structural economic models when forecasting exchange rates? This is the leading question analysed in this paper. In contrast to other studies expectations are used instead of realized data. Therefore, the implicit structural models forecasters have in mind when forming their exchange rate expectations are used. Using expected short- and long-term interest rates and business expectations as explanatory variables latent structural models are estimated to explain expected exchange rates. A special hypothesis is whether exchange rate expectations are formed according to monetary models. The currencies included in the study are the US dollar, British pound, Japanese yen, French franc and Italian lire, each defined against the German mark. A major finding of the analysis is that expected GDP is the most important variable (from the set of our variables) for the determination of exchange rate expectations. For the DM/US dollar expectations a Mundell-Fleming type model is compatible with the data. This means, that increasing interest rates will lead to an appreciation of the corresponding currency. The opposite result have been found for French franc and Italian lire where high expected interest rates indicate a weak currency.