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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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Suggested Citation

  • William A. Barnett, Chang Ho Kwag, 2006. "Exchange Rate Determination from Monetary Fundamentals: an Aggregation Theoretic Approach," Frontiers in Finance and Economics, SKEMA Business School, vol. 3(1), pages 29-48, June.
    • Handle: RePEc:ffe:journl:v:3:y:2006:i:1:p:29-48
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    2. Gangopadhyay, Partha, 2020. "A new & simple model of currency crisis: Bifurcations and the emergence of a bad equilibrium," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 538(C).
    3. Yemba, Boniface P. & Otunuga, Olusegun Michael & Tang, Biyan & Biswas, Nabaneeta, 2023. "Nowcasting of the Short-run Euro-Dollar Exchange Rate with Economic Fundamentals and Time-varying Parameters," Finance Research Letters, Elsevier, vol. 52(C).
    4. Ghosh, Taniya & Bhadury, Soumya Suvra, 2018. "Has Money Lost Its Relevance? Resolving the Exchange Rate Disconnect Puzzle," MPRA Paper 90627, University Library of Munich, Germany.

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    Keywords

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    JEL classification:

    • C43 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Index Numbers and Aggregation
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications

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