Identifying the role of exchange rates in stabilizing open economies: A structured econometric analysis within the classical monetary framework

Whether a monetary policy (rule) aiming at stabilizing the economy efficiently should take exchange rate movements into consideration is an issue that recently has drawn a lot of attention. So far, however, no persuasive empirical evidence on the topic has been provided. Using well-established long-run economic equilibrium conditions building on traditional monetary views and by using cointegration analysis, we provide quantitative policy predictions indicating that there are strong fundamentals motivating exchange rate control in conducting monetary policy. The estimated effects of changes in money stock, exchange rates, price level movements and other types of economic impulses, are fully consistent with the theoretical predictions. These results not only support the robustness of the traditional monetary modelling framework but also suggest that the novel estimation procedures presented seem promising for future research in the area.