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Exchange Rate Determination from Monetary Fundamentals: an Aggregation Theoretic Approach

Author

Listed:
  • William Barnett

    (University of Kansas)

  • Chang Ho Kwag

    (POSCO Research Institute)

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 Barnett & Chang Ho Kwag, 2005. "Exchange Rate Determination from Monetary Fundamentals: an Aggregation Theoretic Approach," International Trade 0505004, University Library of Munich, Germany, revised 24 Oct 2005.
  • Handle: RePEc:wpa:wuwpit:0505004
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    References listed on IDEAS

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    Cited by:

    1. 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).

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    More about this item

    Keywords

    Exchange rate; forecasts; vector error correction; aggregation theory; index number theory; Divisia index number;
    All these keywords.

    JEL classification:

    • E - Macroeconomics and Monetary Economics

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