The Monetary Approach to the Exchange Rate of Bangladesh: A Cointegration Approach

Abstract

The paper estimates a model to determine the exchange rate movements for the Bangladeshi Taka (BDT) face to face US Dollar (USD) using monetary approach. The results using yearly data for the period of 1976 to 2016 assure long-run relationships among the variables. The study uses the Johansen cointegration technique and finds that exchange rate is cointegrated for the monetary fundamentals. As such, the model is compatible with standard international economic theory. The study uses the Vector Error Correction Model (VECM) and finds the long run as well as the short run relationships among the monetary fundamentals and the exchange rate. The study uses the CUSUM and CUSUM-SQ test to identify the structural stability of the model. It is found that there is a long run relationship among the considered variables and the model is structurally stable. The paper finds that the money supply and the GDP play the key role to determine the exchange rate, i.e., the money supply has a positive impact on the exchange rate and the GDP has a negative impact on the exchange rate. The paper does not support the monetarist hypothesis that a higher interest rate leads to appreciate the exchange rate. Therefore, the monetarist hypothesis deserves further rigorous empirical investigation in the context of Bangladesh. Although the inflation is statistically significant, it is not consistent with the many other variants of the monetary models.

Keywords: Monetary approach, ADF test, Cointegration, VECM test, Exchange rate, Bangladesh.