An empirical investigation of the flexible price monetary model of the exchange rate: The case of Colombia

The monetary model of the exchange rate has proven to be an unreliable representation of exchange rates. Nevertheless, the monetary model is applied to the case of Colombia in this study. There are two reasons to believe that the model may offer an accurate description of exchange rates for Colombia. First, Colombia is a moderately high inflation economy, especially when compared to G7 countries. Second, the target zone arrangement established since 1991 was not fully credible, and as a result, the exchange rate appropriates a purely flexible exchange rate system. The results show that since 1980, the relation between exchange rates and monetary fundamentals has changed. Likely factors that occurred since February 1990 include: the establishments of new financial liberalization policies, the abandonment of the crawling peg system of exchange rates in favor of a target zone arrangement, and greater political uncertainty. The main finding of this study is that the monetary model appears to fit the Colombian peso since February 1990. Out-of-sample forecasts based on the monetary model outperform forecasts generated by a random walk model at horizons grater than 3 months.