Empirical Investigation of the Effects of the Fundamentals on the Exchange Rate

Abstract

This paper examines, by using several econometric techniques, the effects of foreign reserves and other fundamental variables on the exchange rate using the target zone theory. This paper uses monthly data for Chile from January 1979 to November 1997. The data used consists of foreign reserves, credit from the Central Bank, domestic reserves, imports, exports, claims on government, GDP, foreign liabilities, domestic and foreign interest rate. We find that the interest differential does not have any effect on depreciation, rejecting the target zone implication that the domestic interest rate can be used to manage the exchange rate. We find that foreign reserves support the exchange rate by reducing the exchange rate depreciation, and the exchange rate and foreign reserves follow a negative relationship, which supports the assumption that increasing the foreign reserves appreciates the exchange rate.