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Exchange Rate Determination Under Monetary Policy Rules In A Financially Underdeveloped Economy: A Simple Model And Application to Mozambique

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Executive Summary

Microstructure aspects of nominal exchange rate determination are less relevant in countries with embryonic financial markets. In less-developed economies, trade in goods and services is a more significant driver of currency demand than financial market speculation or hedging; and central banks actively set monetary variables. The authors develop a simple variation of the standard monetary model of exchange rate determination, incorporating interest rate rules but not relying on interest rate parity; and study the effect of monetary fundamentals on the Mozambican exchange rate. They find a long-run relationship between fundamentals and exchange rates, with coefficient signs in regression equations consistent with theoretic predictions.

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