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Exchange Rate Determination from Monetary Fundamentals: an Aggregation Theoretic Approach

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  • William A. Barnett, Chang Ho Kwag

    () (University of Kansas)

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.'

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Bibliographic Info

Article provided by SKEMA Business School in its journal Frontiers in Finance and Economics.

Volume (Year): 3 (2006)
Issue (Month): 1 (June)
Pages: 29-48

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Handle: RePEc:ffe:journl:v:3:y:2006:i:1:p:29-48

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Web page: http://www.ffe.esc-lille.com

Related research

Keywords: exchange rate; froecasts; vector error correction; aggregation theory; index number theory; Divisia index nummber;

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  1. Kilian, Lutz, 1999. "Exchange Rates and Monetary Fundamentals: What Do We Learn from Long-Horizon Regressions?," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 14(5), pages 491-510, Sept.-Oct.
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  3. Cheung, Yin-Wong & Chinn, Menzie David & Garcia Pascual, Antonio, 2003. "Empirical Exchange Rate Models of the Nineties: Are Any Fit to Survive?," Santa Cruz Department of Economics, Working Paper Series qt12z9x4c5, Department of Economics, UC Santa Cruz.
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  5. William Barnett & Shu Wu, 2004. "On user costs of risy monetary assets," WORKING PAPERS SERIES IN THEORETICAL AND APPLIED ECONOMICS 200404, University of Kansas, Department of Economics, revised Jun 2004.
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