Uncovering the link between a flexible exchange rate and fundamentals: the case of Central and Eastern European economies

Marek Dąbrowski, Monika Papież () and Sławomir Śmiech ()

Applied Economics, 2018, vol. 50, issue 20, 2273-2296

Abstract: This article examines the link between a nominal exchange rate and macrofundamentals in Central and Eastern European (CEE) countries. We use the model based on the monetary policy rule as a theoretical framework that explains the relations between the exchange rate and price level, risk premium, output gap, and expected inflation. It allows for endogeneity of the monetary policy – the issue ignored in the widely used monetary model. The sample covers the period January 2000 – December 2014, so the data are not plagued by high-inflation differentials characteristic for the early transition period and include countries with relatively flexible exchange rates. Our empirical strategy employs the panel error correction model that allows for cross-sectional dependence and a series of panel causality tests. The main finding is that the nominal exchange rates in CEE countries are not disconnected from macrofundamentals implied by the Taylor rule-based model. More specifically, we find that there is a strong cross-sectional dependence among CEE countries, exchange rates Granger-cause macrofundamentals and tend to revert to the long-run relation, and that the results are robust to the ‘extraordinary circumstances’ argument, i.e. do not rest on the dynamics during the global financial crisis.

Date: 2018
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DOI: 10.1080/00036846.2017.1394974

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