To test our hypothesis, all that remains to be determined is the relevant proxy for the quantity of money and the quantity of goods. Since the money is interchangeable, it follows that the demand for money encompasses at least all the countries in the fixed exchange rate area, which is the real GDP of the whole monetary union area. In this case, the relevant quantity of money is nothing more than the combined money supply of the monetary union. Obviously, the limiting case on the upside being the whole world. All of this means that there is a single market for the money, the world, and that the purchasing power of that money is determined by global demand and supply conditions. Assuming perfect mobility of goods across national borders, the prices of goods will be determined in the global economy and so will the purchasing power of the currency. Hence, the inflation rate, while still a monetary phenomenon, will be determined by the global money supply growth and the global real GDP growth.

The zero substitution assumption makes the empirical job significantly easier. All one need is the local money and local GDP to determine the local inflation rate. But there is a bonus. As the locals only use the local currency, that is, the zero substitutability assumption, the exchange rate reflects the price of one currency in terms of another and the inverse of the CPI denotes the price of a currency in terms of goods, its purchasing power. It follows that the exchange rate will reflect the ratio of the two countries’ CPI. The exchange rate changes reflect changes in the CPI, which in turn are determined by too much money chasing too few goods in each of the localities. The percent changes in the exchange rate will be determined by the growth in the quantity of money and real GDP growth rates in each of the economies.

The next issue to discuss is what is the relevant quantity of money? As we have already mentioned in many parts of the world, the capital markets are not as developed as in the United States. Also in these economies, financial institutions are highly regulated. To the extent that these regulations are effective and or expensive to evade, the money multiplier will not be as flexible, and as such it will not be able to offset a significant fraction of a change in the domestic monetary base. This means that the local central bank controls both the monetary base and to a great extent the broader monetary aggregates. Hence, all of the monetary aggregates are potential proxies of the quantity of money chasing goods. The area with the relative too much money chasing relative too few goods will experience a depreciating currency. In this case, we only need four pieces of information, the two countries’ money growth and real GDP growth.

The one-way substitution effect produces an interesting insight. As individuals in different countries substitute in and out of the dollar, the amounts of dollars circulating in the rest of the world changes. Some currency will enter those countries legally and be recorded in the respective countries’ balance of payments. Alternatively, the dollars could enter in an unregistered manner, in which case they will not be recorded in the balance of payments. They will be recorded in the errors and omissions entry of the balance of payment accounts. The recorded and unrecorded inflow of US dollars may be meaningful in many of these countries. This gives us an interesting insight. Even though the local monetary authorities control the domestic money circulation in the economy, they will not have complete control of the dollars circulating and as a result they will not have full control of the quantity of money circulating in its economy, that is, the pesos plus dollars. Also to the extent that the dollar displaces the pesos, the demand for pesos declines and that leads to an inflation rate much higher than that predicted by the flexible exchange rate model that assumes no currency substitution.

From the US perspective, most people will argue that countries such as Thailand are too small compared to the US economy. Hence a shift in the demand for dollars for transaction purposes will have little or no impact on the US economy. The policy implication being that the US monetary authorities should not be concerned about the impact of these one-way substitution effects on the economy. But that could be a mistake. The sum of little effects can add up to a significant and large effect on the US inflation rate. It will depend on the rest of the world real GDP growth as well as the rest of the world money supply growth relative to that of the United States.

Depending on the organization of the US monetary system, the foreign fluctuations in the demand for money will impact the US inflation rate. In fact, we argue that keeping track of the rest of the world’s use of dollars may be an arduous task for individual investors and analysts. There is one short cut they can take. One can argue that the US inflation rate captures the changes in the US money market equilibrium. As such, it captures the impact of the changes in the US and rest of the world growth in real GDP and monetary aggregates. More importantly, the shortcut is invariant to the organization of the monetary system.

Take the case of a domestic price rule as an example. In this scenario, the US central bank accommodates the domestic and foreign demand for US dollar to insure that it meets the target inflation rate. If that is the case, and the currency of the country in question is only used in that country, all one needs to worry about is the US inflation rate and the individual countries money supply and real GDP growth. However, to the extent that the United States is not following a domestic price rule, the potential world demand for dollars has to be taken into consideration. A way to pick up the effect on the overall equilibrium condition is simply to use the US inflation rate.

The results of the estimation are reported in Table 31.1. A summary of the results is quite interesting:

Collectively, the results suggest that local conditions, in particular local real GDP growth, are a major driver of the fluctuations in the exchange rate. The data also suggests that the growth in the US monetary aggregates and real GDP has little or no impact on the exchange rate movements. One possible explanation for this result points to the organization of the monetary system. If the Fed was in fact operating under a domestic price rule and it effectively ceded the open market operations to the private sector, by targeting the inflation rate, it fixed the rate of change of the purchasing power of money, it effectively made the money perfect substitutes to the consumer basket. They are interchangeable at the underlying inflation rate. The Fed would accommodate shifts in the demand for money in such a way that the target inflation would be met. We have already argued that under these conditions the quantity of money and the real GDP would not have a significant effect on the underlying inflation rate.

The logic also extends to the foreign countries. If they fix their domestic price or exchange rate system, there should be little or no correlation between the domestic money growth, real GDP growth, and the underlying inflation. The fixed exchange rate country will be importing its inflation rate from the country to which it fixes its exchange rate. There is one special case in the sample that allows us to explicitly test this interpretation: Hong Kong. With its currency board and fixed exchange rate to the US dollar, Hong Kong meets all the requirements that we have outlined. The Hong Kong equation estimated coefficients are not statistically significant as predicted by this argument.

Table 31.2 reports the results for the exchange rate equation using M3 as the relevant monetary aggregate. The results are not much different than those produced when the monetary base is used as the relevant monetary aggregate. This fits the monetarist view that the monetary authorities exercise control over the monetary base and M3. We attribute this to the fact that the financial system in the rest of the world countries in our sample is much less developed and that allows the local central banks greater control over the broader aggregates.

One common element of the results reported in Tables 31.1 and 31.2 is the lack of statistical significance of the US monetary aggregates and the US real GDP growth. Possible reasons for these results may be the fact that the United States was pursuing a domestic price rule as we already explained. Another reason may be that the specification is not taking into account the rest of the world demand for US dollars, that is, the currency substitution effect. There are two ways to correct or account for this. One is to calculate the world demand for and supply of US dollars. We already did this in an earlier chapter and found support for this view as it improved the explanatory power of the US inflation equation. But this is a tedious process, as it requires that one convert all of the countries’ money supply into US dollars to arrive at a world money supply figure. Fortunately, there is a short cut. According to our framework, the US inflation rate is nothing more than the rate of change of the market clearing equilibrium conditions. Therefore, one can use the US inflation rate to replace the world money demand and money supply conditions in estimating the nominal exchange rate changes.

Estimates of the changes in the nominal exchange rate using the local monetary base and real GDP growth rates, as well as the US inflation rate are reported in Table 31.3. While the results for the local variables are essentially unchanged when compared to the results reported in Table 31.1, the US inflation is statistically significant in 22 of the 32 countries. Replacing the monetary base with M3 yields similar results (Table 31.4). In both cases, there is a marked improvement over the significance level of the US monetary aggregates and real GDP growth rate reported in Tables 31.1 and 31.2.

A summary of the statistically significant coefficients produced by the different variables in the different equations is reported in Table 31.5. The results are consistent with the view that domestic excess money creation leads to a currency depreciation, while the US inflation leads to a currency appreciation in the foreign countries.

The results also point to the weakness of the explanatory power of the monetary aggregates. Very few of the domestic monetary aggregates are statistically significant. There may be several possible explanations for this result. Our favorite has to do with the conduct of monetary policy. The belief that the exchange rate manipulation can affect a country’s terms of trade is a fairly strong one. Many governments manage the exchange rate and as a result take steps to prevent the domestic currency from appreciating beyond a target level. In effect, this is nothing more than a fixed exchange rate band.