An aggregation theoretic approach to exchange rate determination using Divisia indices

The asset approach has been developed to explain the erratic fluctuations shown by exchange rates during the recent floating period. The asset approach views the exchange rate as the relative price of two national currencies. The money market has been brought to the forefront and serves as the basic structure of the asset approach models. However, important factors of the money market have not received due attention. Particularly, substitution effects among monetary assets are not properly treated and implemented.; To deal with substitution effects such as currency substitution and money-nearmoney substitution effects, aggregation and index number theory is combined into the exchange rate model. Substituting Divisia indices for the money supply and the opportunity cost variables, a theoretical model is developed to test the existence of all relevant substitution effects and to implement them into the exchange rate model. The constructed model is empirically verified on the basis of its performance in explaining exchange rate movements.; Results show that substitution effects among monetary assets are significant and have to be implemented in the exchange rate model. The model with Divisia indices shows considerable improvement in explaining exchange rate movements. For the empirical analysis, quarterly Canadian and U.S. data for the period of 1973:I to 1983:I are used.