Econometric Evaluation of the Exchange Rate in Models of the UK Economy

This paper evaluates the exchange rate mechanisms in current large-scale models of the U.K. economy and finds that each has some shortcomings. A new, econometrically preferable, specification is developed. Previous empirical failures of exchange rate models relate to an inadequate treatment of expectations and neglect of the simultaneity between exchange rates and interest rates: the instrumental variable methods employed here remedy these deficiencies. The preferred equation, a forward-looking modified uncovered interest rate parity relation, outperforms a random walk. The sensitivity of overall model properties is examined by replacing the existing equations with the new equation and repeating standard simulation experiments. Coauthors are S. K. Tanna, D. S. Turner, K. F. Wallis, and J. D. Whitley. Copyright 1990 by Royal Economic Society.