Monetary model of exchange rate determination: evidence from the Czech Republic, Hungary and Poland

Using a monetary model of exchange rate determination that suggests a strong link between the nominal exchange rate and a set of monetary fundamentals, exchange rate dynamics for the Czech Republic, Hungary and Poland is studied. As the cointegration relationship between exchange rate, output and the monetary fundamentals (money supply and interest rate) is found, VAR/VEC and 2SLS error-correction models are used in this context, since both approaches allow estimate short-run correlations between exchange rates and fundamentals while taking into account the existent long-run exchange rate constraints. Based on the quarterly data for the 1998-2012 period, it is found that for all countries an increase in the money supply, domestic output slowdown or stronger growth abroad are factors behind a nominal exchange rate depreciation, just as predicted by the monetary model of exchange rate. However, the effects of domestic-foreign interest rate differential are quite heterogeneous, being in line with theoretical predictions of a standard monetary model for Poland only. According to the decomposition of variance, money supply and interest rates account for 30% to 46% of the exchange rate variation in the Czech Republic, from 10% to 14% in Hungary, and from 23% to 42% in Poland.