EXCHANGE RATE DETERMINATION UNDER MONETARY POLICY RULES IN A FINANCIALLY UNDERDEVELOPED ECONOMY: A SIMPLE MODEL AND APPLICATION TO MOZAMBIQUE
Article first published online: 10 JUL 2011
Copyright © 2011 John Wiley & Sons, Ltd.
Journal of International Development
Volume 25, Issue 4, pages 502–519, May 2013
How to Cite
Hassan, S. and Simione, F. (2013), EXCHANGE RATE DETERMINATION UNDER MONETARY POLICY RULES IN A FINANCIALLY UNDERDEVELOPED ECONOMY: A SIMPLE MODEL AND APPLICATION TO MOZAMBIQUE. J. Int. Dev., 25: 502–519. doi: 10.1002/jid.1806
- Issue published online: 17 APR 2013
- Article first published online: 10 JUL 2011
- Manuscript Accepted: 31 MAR 2011
- Manuscript Revised: 23 MAR 2011
- Manuscript Received: 25 JUL 2010
- nominal exchange rate determination;
- interest rate rules
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. Copyright © 2011 John Wiley & Sons, Ltd.