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Exchange Rate Determination from Monetary Fundamentals: An Aggregation Theoretic Approach

In: Financial Aggregation And Index Number Theory

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  • William A. Barnett

    (University of Kansas, USA)

  • Chang Ho Kwag

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."

Suggested Citation

  • William A. Barnett & Chang Ho Kwag, 2011. "Exchange Rate Determination from Monetary Fundamentals: An Aggregation Theoretic Approach," World Scientific Book Chapters, in: Financial Aggregation And Index Number Theory, chapter 5, pages 151-166, World Scientific Publishing Co. Pte. Ltd..
  • Handle: RePEc:wsi:wschap:9789814293105_0005
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    More about this item

    Keywords

    Index Number Theory; Aggregation Theory; Money; Financial Assets; Monetary Aggregates;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • E - Macroeconomics and Monetary Economics

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