Abstract
In this chapter we turn to a fundamentals-based approach to modelling the nominal exchange rate which is closely associated with PPP, namely the monetary approach to the exchange rate. However, although various guises of the monetary approach — most notably the flexible price and sticky-price approaches — rely on PPP as a long-run construct, their motivation is quite different since they view the exchange rate as the relative price of two monies (i.e. assets), rather than purely the relative price of commodities. Interpreting the exchange rate in this way yields important insights into why floating exchange rates are more volatile than underlying economic fundamentals. This may be illustrated by referring to table 4.1, where the coefficients of variation of three series are presented for a number of representative countries. The series are: the log of the bilateral US dollar exchange rate; the log of the ratio of the country’s consumer price index (CPI) to the US CPI; the difference between the country’s three month euro-interest rate and that of the US (interest rates are expressed as proportions).1
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MacDonald, R., Marsh, I. (1999). The Monetary Approach to Exchange Rate Modelling. In: Exchange Rate Modelling. Advanced Studies in Theoretical and Applied Econometrics, vol 37. Springer, Boston, MA. https://doi.org/10.1007/978-1-4757-2997-9_4
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DOI: https://doi.org/10.1007/978-1-4757-2997-9_4
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