ONE APPROACH TO RESOLVE THE EXCHANGE RATE PUZZLE: RESULTS USING DATA FROM THE UNITED KINGDOM AND THE UNITED STATES

Abstract

We approach a significant research topic in international economics by restating the test procedures in a novel manner consistent with monetary theorems with controls using monetary variables and applying an appropriate econometric methodology to re-examine three aspects of exchange rate behavior. (i) Does the inflation (price) factor affect Nominal Exchange Rate (NER)? (ii) Do relative interest rates between countries affect a country’s exchange rate? (iii) Do the price and interest rate effects hold if controls for non-parity factors are embedded in tests? The data series for this study are taken over 55 years covering pre-and-post-Bretton Woods era: a second test was done over the post-Bretton Woods period only using 30 years of data. Also, the traditional factors of parity conditions are extended in this research to take into account recently theorized and tested non-parity factors related to cash flows. The resulting evidence affirms clearly that both the parity factors (prices and interest rates) and the non-parity factors affect exchange rates significantly over the long run, also over the 30-year period. In our view, these findings extend our knowledge of how currency behavior is consistent with parity and non-parity theorems.