On the correct model specification for estimating the structure of a currency basket

Abstract

A strand of literature has focused on inferring the weights of the anchor currencies in a country’s currency basket. With the growing importance of China’s economy, there has been a surging research interest in the role of the renminbi as an international anchor currency and in China’s de facto exchange rate regime. In this article, we show by a simple model and demonstrate using the observed data on the Special Drawing Rights basket that the correct specification to estimate the weights of anchor currencies in a currency basket is to use the rates of change in exchange rates and to write exchange rates in quantity term. When one is to estimate the structure of a currency basket, close attention should be paid to using the rates of change or the levels of exchange rates as well as writing exchange rates in quantity or price term.