Working Paper: NBER ID: w0429
Authors: Kenneth W. Clements; Jacob A. Frenkel
Abstract: This paper applies the analytical framework of the monetary approach to exchange rate determination to the analysis of the Dollar/Pound exchange rate during the first part of the 1920's. The analysis uses monthly data up to the return of Britain to gold in 1925. The equilibrium exchange rate is shown to be influenced by both real and monetary factors which operate through their influence on the relative demands and supplies of monies. Special attention is given to examination of the relationship between exchange rates and the relative price of traded to non-traded goods. In the empirical work the prices of traded goods are proxied by the wholesale price indices and the prices of non-traded are proxied by wages. One of the key findings of the paper is the estimate of the elasticity of the exchange rate with respect to the relative price of traded to non-traded goods. This elasticity is estimated with high precision and is shown to be .415 which provides an independent measure of the relative share of spending on non-traded goods. This estimate is consistent with other estimates obtained in studies of expenditure shares. The paper concluded with a dynamic simulation which indicates the satisfactory quality of the predictive ability of the model.
Keywords: exchange rates; monetary approach; relative prices; traded goods; nontraded goods
JEL Codes: F31; E41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| equilibrium exchange rate influenced by real and monetary factors (F31) | relative demands and supplies of money (E41) |
| rise in domestic relative price of traded goods (F16) | depreciation of currency (F31) |
| rise in domestic money supply (E51) | depreciation of currency (F31) |
| ten percent rise in ratio of domestic to foreign income (F29) | 19 percent depreciation of home currency (F31) |
| relative price of traded goods (F16) | exchange rate (F31) |