Monetary and Asset Market Models for Sterling Exchange Rates: A Cointegration Approach

The aim of this paper is to investigate the determination of bilateral sterling exchange rates over the floating period 1973Q1-1990Q3. The exchange rates covered are: US dollar/pound, D-mark/pound, yen/pound, and F-franc/pound. We provide an econometric evaluation of the main exchange rate theories, using the cointegration-error correction methodology and non-nested tests. We have been unable to find any statistical evidence in support of a long-run relationship consistent with the various monetary models. The empirical results for the long-run and dynamic exchange rate equations provide strong support for a modified uncovered interest rate parity and the portfolio balance models.