Working Paper: NBER ID: w0766
Authors: 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.
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Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| money supply differential (E51) | exchange rate (F31) |
| income differential (J31) | exchange rate (F31) |
| interest rate differential (E43) | exchange rate (F31) |
| past values of the error term (C22) | current error term (C20) |
| deviations from purchasing power parity (F31) | autoregressive error term (C22) |