Exchange Rate Determination Under Monetary Policy Rules in a Financially Underdeveloped Economy: A Simple Model and Application to Mozambique
Microstructure aspects of nominal exchange rate determination are less relevant in countries with embryonic financial markets. In less-developed economies, trade in goods and services is a more significant driver of currency demand than financial market speculation or hedging; and central banks actively set monetary variables. We develop a simple variation of the standard monetary model of exchange rate determination, incorporating interest rate rules but not relying on interest rate parity; and study the effect of monetary fundamentals on the Mozambican exchange rate. We find a long-run relationship between fundamentals and exchange rates, with coefficient signs in regression equations consistent with theoretic predictions. Moreover, the monetary model outperforms a random walk in predicting metical exchange rates out-of-sample at the four-quarter horizon.
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