Monetary Commitment and the Relationship Between Exchange Rates and Relative Prices: Evidence From a Panel of Emerging Countries

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Utilizing Granger causality tests within a panel co integration framework; this paper investigates the impact of central bank independence (CBI) on the causal relationship between relative prices and exchange rates for a panel of 26 emerging countries. The time period for the analysis spans 1970 through 2000. The results of the analysis offer no evidence whatsoever of a long run causal relationship between the variables of interest. The causal relationship for the short run is unidirectional and runs only from relative prices to exchange rates. A subdivision of the full country panel into "high CBI' and "low CBI' groups, however, yields strikingly different causal relationship between the variables for the two groups of countries. For the "high CBI" countries we find that causality between relative prices and exchange rates is bi-directional both in the short and the long run. In contrast, evidence for such bi-directional causal links between the variables is restricted to the short run for "low CBI" countries. In terms of policy implications, the contrasting results suggest that PPP may serve as a potential tool for currency realignment in "high CBI" countries.

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