Testing the monetary model of exchange rate determination: a closer look at panels

In this paper, we undertake an extensive evaluation of panel tests of the long-run monetary model of exchange rate determination. We first show how poorly the monetary model performs on a country-by-country basis for US dollar exchange rates over the post-Bretton Woods period for a large number of industrialized countries. In sharp contrast, we find considerable support for the monetary model using panel procedures, as in Groen (2000) and Mark and Sul (2001). Given the disparity in the country-by-country and panel approaches, we carefully analyze the homogeneity restrictions inherent in the panel procedures. The evidence on the appropriateness of the homogeneity restrictions is mixed. In the end, whether the monetary model conforms to post-Bretton Woods data largely depends on one’s prior beliefs.