Exchange Rate Determination from Monetary Fundamentals: an Aggregation Theoretic Approach

William Barnett () and Chang Ho Kwag
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Chang Ho Kwag: POSCO Research Institute

No 200513, WORKING PAPERS SERIES IN THEORETICAL AND APPLIED ECONOMICS from University of Kansas, Department of Economics

Abstract: We incorporate aggregation and index number theory into monetary models of exchange rate determination in a manner that is internally consistent with money market equilibrium. Divisia monetary aggregates and user-cost concepts are used for money supply and opportunity-cost variables in the monetary models. We estimate a flexible price monetary model, a sticky price monetary model, and the Hooper and Morton (1982) model for the US dollar/UK pound exchange rate. We compare forecast results using mean square error, direction of change, and Diebold-Mariano statistics. We find that models with Divisia indexes are better than the random walk assumption in explaining the exchange rate fluctuations. Our results are consistent with the relevant theory and the 'Barnett critique.'

Keywords: Exchange rate; forecasts; vector error correction; aggregation theory; index number theory; Divisia index number (search for similar items in EconPapers)
JEL-codes: F31 G15 E (search for similar items in EconPapers)
Date: Written
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Related works:
Working Paper: Exchange Rate Determination from Monetary Fundamentals: an Aggregation Theoretic Approach (2005)
Journal Article: Exchange Rate Determination from Monetary Fundamentals: an Aggregation Theoretic Approach (2006)
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