Cross-section dependence and the monetary exchange rate model – A panel analysis

This paper tackles the issue of cross-section dependence for the monetary exchange rate model in the presence of unobserved common factors using panel data from 1973 until 2007 for 19 OECD countries. Applying a principal component analysis we distinguish between common factors and idiosyncratic components and determine whether non-stationarity stems from international or national stochastic trends. We find evidence that the common factors are I(1) while the idiosyncratic components are I(0). This finding indicates that cross-member cointegration exists and non-stationarity in exchange rates and fundamentals is mainly driven by common international trends. We find evidence that the common factors of the exchange rates and fundamentals are cointegrated. In addition, the estimated long-run coefficients of this common international relationship are in line with the suggestions of the monetary model with respect to income and money.

► This paper tackles the issue of cross-section dependence for the monetary exchange rate model applying a principal component analysis.
► Our framework allows to distinguish whether non-stationarity stems from international or national stochastic trends.
► We find evidence that cross-member cointegration exists and non-stationarity in exchange rates and fundamentals is mainly driven by common international trends. Another interesting result is that common factors of the exchange rates and fundamentals are cointegrated.