SFB 303 Discussion Paper No. B - 065

Author: Krelle, Wilhelm, and Heinz Welsch
Title: Exchange Rate Determination for Interdependent Economies
Abstract: Exchange rates are important economic variables, but (in a regime of flexible exchange rates) difficult to predict. In the short run, they are statistically almost pure chance variables, see Granger and Morgenstern (1970). Otherwise it would be possible to make sure profits by using the exchange rate equation as forecasting device. As a rule, capital flows are very volatile, and they, unfortunately, determine the exchange rates to a larger extent than the much larger, but relatively stable flows of exports and imports. In the case of exchange rates, "the tail wags the dog". But in the long run the economic forces prevail: there are tendencies towards purchasing power parity and towards interest rate parity. Thus we may hope to explain the yearly (or quarterly) averages of the exchange rates by economic theory and test this explanation by econometric methods.

There are different approaches to exchange rate determination. They may be grouped into the monetary approach and the balance of payments approach. The first prevails in pure theory, the latter in econometric forecasting systems which try to simulate economies in detail and forecast exchange rate developments for practical economic policy. In the theoretical approach, two-country models prevail. Simultaneous determination of exchange rates in the context of multi-country-models is a complicated matter and has seldom been attempted. This will be done in the present paper.
Creation-Date: September 1985
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