Question 13.3: It is possible to use the monetary model to predict the euro...

The analyst needs to assess monetary policy in the two countries. Moreover, he must assess expectations about the future exchange rate. If the market’s expectation of the future exchange rate were to change, the current exchange rate would move in the same direction.
All the fundamentals act simultaneously in determining the forecast on exchange rate. It is therefore useful for the analyst to use a statistical model allowing to combine the effect of all the variables.
The use of the monetary model in practice is made difficult by the lack of knowledge about the true value of the economic fundamentals, which is often ignored by the analyst.
The main variables of interest are in fact never known for sure, but they are normally forecasted given the current available economic data. In this sense, expectations about the future of the exchange rate are unobservable, therefore even harder to assess.
Assuming the monetary model is valid, the forecast about exchange rate is successful, and then the predictions about fundamental values are good. After early success, the model was proven to fail empirically, except in very extreme conditions.
After the failure of the monetary model, economists went to work developing other ideas. Rudiger Dornbusch developed a variant of the monetary model called the overshooting model.
The model assumes that the average level of prices is fixed in the short term, matching the assumption that prices in the real world change very seldom. The assumption has the effect to overshoot its long-run value as a result of a change in the fundamentals and then turning back to the long-run value.
Also the modified model was soon shown to fail empirically. In particular, the model lacks a strong statistical relationship between the fundamentals and the exchange rate. That relationship should in fact exist if the model were true.
The portfolio balance model is another extension of the monetary model, in which the determinants of the exchange rate are the supply and demand of foreign and domestic bonds together with the demand for foreign and domestic money.
The model itself has proven to fail, but further versions have been developed, taking into account an optimal solution for the choice of bonds and money in the portfolio. According to such a theory, the substitution rate of domestic for foreign bonds depends on the risk aversion of the investor and on the volatility of the returns on the bonds. Moreover, the correlation between the returns on the different bonds in the portfolio is also important.
It turns out from the empirical application that the three major models of the exchange rate, namely, the monetary, the overshooting, and the portfolio balance models, do not provide a satisfactory account of the exchange rate.
The news about the fundamentals are important drivers of the exchange rate, and market participants form expectations about the value of the money supply before the government announces the money supply figures.

These expectations drive the investment decisions of traders to whether buy or sell currency. Once the investment decisions are made, the interaction of those on the market determines the current level of the exchange rate.
Market participants trade currencies following the announcements about relevant macroeconomic measures, like the change in money supply. Thus, news about fundamentals, under this view, is an important determinant of the exchange rate.