An error correction model for exchange rates with currency substitution: Canadian dollar - United States dollar case

In this study an error correction model for the Canadian-US exchange rates, interest rates, money supplies, prices and incomes is developed for the period of January 1972-March 1976. These variables are selected to question (1) whether a monetary exchange rate determination model is able to explain the movements in the exchange rates and (2) whether the currency substitution hypothesis that relaxes the assumptions of the monetary model is compatible with the data set in question.; The economic variables are primarily I(1) processes, and Johansen's cointegration analysis is applied for the unrestricted variable space. In this analysis it is found that two cointegration vectors exist for unrestricted variables of the model. The assumption of the monetary model (that the income and interest elasticities of demand for money are symmetric for both countries) is explicitly imposed on the long-run relations that are found in the cointegration analysis of the unrestricted variable space. Results show limited support for the symmetry restrictions, though no support is found for the monetary model without the currency substitution assumption. The unrestricted variables supported the interpretation of the cointegration vectors as the demand for money equations with currency substitution.; Later, the variable space is reduced by imposing symmetry. The cointegration analysis on the relative interest rates, relative prices, relative incomes, relative monies and the exchange rates obtains a unique cointegration vector. When this long-run relation is tested for the hypothesis of currency substitution, it is supported. However, some of the signs of the estimated long-run equilibrium relationship are contrary to the implied signs in the theoretical model. Finally, the cointegration vector is used to estimate a dynamic error correction model which is conditioned on the weakly exogenous variables, i.e., on relative interest rates, relative prices, and relative money supplies.; Estimation results of the short-run system showed that short term discrepancies from the equilibrium for both the exchange rate and output equations will return in approximately a year. It is also found out that relative prices explain most of the short-run movements in the exchange rate and output and that the relative output suffers from money illusion in the short-run, i.e., contemporaneous price inflation affects the relative output positively in the short-run.