An Empirical Study on the Long-Run Determinants of Exchange Rate

The behavior of exchange rates has been an important issue in the international finance literature. Although exchange rate is erratic and unpredictable in the short run, its long-run behavior is believed to be guided by economic fundamentals. This paper empirically tests the long-run determinants of the exchange rate by focusing on the Taiwan/US case. After incorporating productivity differential, foreign reserves, and monetary base in the absolute Purchasing Power Parity (PPP) proposition, where the relative price is the only determinant of the exchange rate, the Johansen's maximum likelihood test results indicate these determinants and the exchange rate are indeed cointegrated: thus a long-run relationship can be established.