The paper develops a short-run econometric monetary model of exchange rate determination. The model assumes a conventional money demand function, markets which are linked by interest arbitrage, adaptive expectations formation, and parameters which are stable over time. One-period-ahead forecasts of the mark/pound rate generated by the model compare favorably with naive model forecasts using monthly data. Stability tests provided evidence of parameter instability in 1976 but correction for it did not improve forecasting accuracy. The inability of monetary models to forecast accurately may be due to the underlying model assumptions rather than parameter instability.Several recent studies of the forecasting performance of monetary exchange rate models have found that forecasts generated by these models were not nearly as accurate as the forecasts of naive models. For example, Rogoff (1983a, 1983b) found that forecasts based on monetary models produced one-month-ahead forecasts which were ten percent to twenty percent less accurate (as measured by rootmean square error) than the naive model forecasts. This inability of monetary models to outperform naive models has called into question the desirability of using monetary models for the purpose of forecasting exchange rates.The monetary models used in these forecasting exercises assume that the exchange rate function is stable, i.e., that the parameters of the function are invariant with respect to time. The models were estimated and forecasts are generated under the assumption that the relationship between the explanatory variables and the exchange rate did not change over time. It has been suggested by Meese and Rogoff (1983a, 1989b), Frankel (1984 and others that the poor forecasting performance of the monetary models might be due to the instability of the underlying structural relationships.

Monetary authorities rarely disclose the true reasons behind their policy reactions. A tracing of the policy reaction function to see if the monetary authority is applying simple rules holds the potential to offer profound insight into the past behavioral relationship between the monetary authority and economic agencies. A reasonable body of knowledge about the direction of monetary policy would, moreover, assist economic agencies in forming their expectations, which would in turn, be useful for the monetary authority in anticipating the likely trends of the overall economy. The main objective of this study is to track de Brouwer and Gilbert (2005) from the Australian financial deregulation era (from 1983 to 2002) to the present. Empirical findings show that the Reserve Bank of Australia (RBA) is more forward-looking when formulating monetary policy rather than backward-looking, and that inflation targeting plays a significant role in stabilizing the output of the economy.

Abstract:Monetary authorities rarely disclose their true reasons for their policy reactions. Tracing the policy reaction function to see if the monetary authority is using simple rules would offer profound insight into the past behavioral relationship between the monetary authority and economic agencies. A reasonable body of knowledge about the direction of monetary policy would assist economic agencies' expectations, which would in turn, be useful for the monetary authority in anticipating the likely trends for the general economy. The main objective of this study is to extend de Brouwer and Gilbert (2005) as from the Australian financial deregulation era (from 1983 to 2002) to the present. Empirical findings show that the Reserve Bank of Australia (RBA) is forward looking when formulating monetary policy rather than backward looking, and that inflation targeting plays a significant role in stabilizing the output of the economy.