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Exchange Rate Determination Under Monetary Policy Rules in a Financially Underdeveloped Economy: A Simple Model and Application to Mozambique

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  • Shakill Hassan
  • Félix Simione

Abstract

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.

Suggested Citation

  • Shakill Hassan & Félix Simione, 2010. "Exchange Rate Determination Under Monetary Policy Rules in a Financially Underdeveloped Economy: A Simple Model and Application to Mozambique," Working Papers 192, Economic Research Southern Africa.
  • Handle: RePEc:rza:wpaper:192
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    Cited by:

    1. Works, Richard Floyd, 2016. "Econometric modeling of exchange rate determinants by market classification: An empirical analysis of Japan and South Korea using the sticky-price monetary theory," MPRA Paper 76382, University Library of Munich, Germany.
    2. Riané de Bruyn & Rangan Gupta & Lardo Stander, 2013. "Testing the Monetary Model for Exchange Rate Determination in South Africa: Evidence from 101 Years of Data," Contemporary Economics, University of Finance and Management in Warsaw, vol. 7(1), March.

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