The empirical methodology or model approach to exchange rate determination in the UK’s sterling pound to the francs or dollar or yen, can be empirically examined using the cointegration method. The VEC (Cointegration and Vector Errorcorrection) (Dawson, Baillie 2007) is the vital applied principle in econometrics. In this regard, VEC principle of Cointegration method is the key components that predict the direction of transaction which means either home country or foreign country in that bilateral dealing.
Secondly, money stock used by home country and is adjustable. Thirdly, it is the real income component depicted by the nation’s GDP as a measure of country’s output ((Rawson 200: 248); therefore its use in arriving at an empirical outcome, depicts the accuracy due to inclusion of key factors that determine exchange rates. Empirical Results Cointegration Tests and Results
In examining the UK exchange rate determination empirically, in relation to the monetary model in its relation to exchange rate determination of other currencies relative to the sterling pound (James 1999 and Renson 2000), UK is regarded as home country while other currencies like USA or Japan or France are regarded as foreign countries. While the money stock that is available used for other countries and UK is adjusted seasonally. The real GDP usually represents the countries income (Tyson 2004: 263) is used to in cointegration test and result.
Employing the Gross Domestic Product (GDP) as a measure of output is due to many reason. These reasons vary in terms of the home country which is the United Kingdom and the bilateral trade partner. In this sense, the use of GDP gives the income of Britain, and most important is that it validates exchange rate model in the long-run of the monetary model of the country. In addition to that, employing GDP unveiling the countries income gives the macro effects and adjustments in their relationships like money-exchange rate, money-income and money-price (Collins 2004: 127).
These relationships take quite some time to materialize. Furthermore there is a change in GDP contribution in the UK which is from domestic production, oil production and investments in the commonwealth states. It is also important to mention that the nominal exchange rate is expressed in terms of UK sterling pound per other currencies in the money market. In which the short term interest rate for UK is represented by three-month Treasury Billy rate (Granger 2002: 205). In UK, there is a cointegration relationship between the real incomes, money supply and nominal exchange rates ((Hudson, Gregory 2003: 201)).
This is usually when the estimated test statistics is above 5 percent of the critical value that is used in testing the zero cointegration existence. Possibly, there is no evidence of parameter instability in the case sterling pound exchange rates in relation to the other bilateral trading partner’s currencies. Conclusion The paper has reappraised the empirical approach of the monetary model of exchange rate determination by employing the coitegration and VEC (vector error- correction).
In determination of the exchange rate empirically, the model prove to be valid in long term due to its validity on the United Kingdom exchange rate determination. From the various scholarly writings and contributions to a wealthy body of knowledge it helps to relate and determine the pound exchange rate in relation other foreign currencies. The model applicability to determining the exchange rate for UK proves to be working but with few cautions that need to be taken into account. For instance, to research well on the model practicality long term data should be used.
Good data to be used should a quarterly data, semi yearly or yearly data since the model produces reliable and credible results in terms of long term calculation that reflect use of the monetary model as a long-run model of exchange rates. Using appropriate data help to eliminate unnecessary contention like the research conducted by Wilford (1980); Haynes and Stone (1981); and Rogoff (1983), in their studies during the period of floating exchange rates to establish support for the model was not in favor of the model, since their evidence did not support the monetary model.
This was because they used weekly and monthly data to arrive at the outcomes of their findings. Furthermore, from a simple money demand and a flexible monetary price this incorporates relative money supplies, incomes, and interest rates of domestic and foreign countries as the proximate determinates of the exchange rate in UK the VEC and cointegration methodology (Davidson, 1998; Dawson, Baillie 2007; Fredrick 1968) results to a better and a more relevant projection of the monetary policy for UK.
The exchange rate determination by the predictive performance of the unrestricted monetarist model which has shown that the forecasting performance of the monetary approach based on the error-correction model outperforms the random walk models (Paul, Glassman 2007: 106). The overall assertion is that the paper has discussed the cointegration methodology in conjunction with the VEC technique that is used to give the determination and projection of the sterling pound exchange rate.
However much should be done to ensure the pound stability as opposed to the depreciation against other major currencies (Federal Reserve Bank of Boston 2008).
Collins, H. (2004) Analysis of Cointegration, Oxford University Press, New York. Davidson, B. (1998), Empirical Models of the Exchange Rate, available at www. journal of internationalbusiness. com, retrieved on 29th July 2008 Dawson, S. & Baillie, L. (2007), Exchange Rate Determination using Cointegration approach,Sample Essay of PapersMart.net