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Exchange Rate Determination and the Demand for Money

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  • Craig S. Hakkio

Abstract

This paper examines the conventional monetary equation of exchange rate determination. Under certain exogeneity conditions, one can write the price level, at home and abroad, as the ratio of the nominal money supply to the demand for real money balances. Then, since the exchange rate is the domestic price of foreign exchange, one can equate the exchange rate to the ratio of domestic to foreign prices. This then allows one to write, and estimate, the exchange rate as a function of the money supply differential, income differential and interest rate differential. If the domestic and foreign money demand errors are autocorrelated, and if deviations from purchasing power parity are autocorrelated, tests based on the above model may be invalid. Only if all autoregressive parameters are equal will test results be valid. A full information maximum likelihood procedure is used to estimate and test the assumptions necessary for the conventional procedure to be correct. Finally, two alternative models of exchange rate determination are considered to illustrate the importance of introducing the error terms at the beginning of the analysis.

Suggested Citation

  • Craig S. Hakkio, 1981. "Exchange Rate Determination and the Demand for Money," NBER Working Papers 0766, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:0766
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    1. Paul R. Milgrom, 1978. "Rational Expectations," Discussion Papers 406, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    2. Rudiger Dornbusch, 1980. "Exchange Rate Economics: Where Do We Stand?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 11(1, Tenth ), pages 143-206.
    3. Betancourt, Roger & Kelejian, Harry, 1981. "Lagged Endogenous Variables and the Cochrane-Orcutt Procedure," Econometrica, Econometric Society, vol. 49(4), pages 1073-1078, June.
    4. Dufour, J.M. & Gaudry, M.J.I., 1981. "Fixed Points and Minima: a Comment on Betancourt and Kelejian," Cahiers de recherche 8117, Universite de Montreal, Departement de sciences economiques.
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    1. Thomas C. Glaessner, 1982. "Formulation and estimation of a dynamic model of exchange rate determination: an application of general method of moments techniques," International Finance Discussion Papers 208, Board of Governors of the Federal Reserve System (U.S.).
    2. Hakkio, Craig S., 1984. "A re-examination of purchasing power parity : A multi-country and multi-period study," Journal of International Economics, Elsevier, vol. 17(3-4), pages 265-277, November.

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