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Keywords:

  • nominal exchange rate determination;
  • Mozambique;
  • interest rate rules

Abstract

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.