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At the time this paper was written, I was working at the Monetary and Exchange Affairs Department of the International Monetary Fund. I presently work at the Research Department of Banco Santander, Spain. Manoj Vasant Pradhan is currently at the George Washington University. We would like to thank Tomás J.T. Baliño, Martin Hardy, Arto Kovanen, Eduardo Levy-Yeyati, Paolo Mauro, Sebastián Paris-Horvitz, and Angel Ubide for useful comments. Lisabeth Moore’s and Kiran Sastry’s research assistance is gratefully acknowledged. Any remaining errors are of course ours.
For a review of past discussions on this issue see Dewald (1988).
Note that M is the same as in equation (1) because what P* intends to measure is the price level that would be attained at the actual money stock if real output and velocity were at their equilibrium level.
In the traditional pure monetary approach to the balance of payments (in which the PPP always holds), the real exchange rate is assumed to be a constant and may be deleted from the analysis.
A valid test for linear restrictions was conducted to make sure that the restriction of equal cofficients for the output and velocity gaps could be carried out.
The choice of the appropriate number of lags of the dependent and independent variables will be based on a number of criteria including the Schwarz-Bayesian Criterion and tests for model reduction.
The choice of the appropriate number of lags will be determined as previously described for the domestic price gap.
This again follows the literature on P-STAR models for small open economies (see Kool and Tatom, 1994).
The ALP (activos liquidos en manos del público) are liquid assets that include final assets that are substitutes to deposits.
Structural techniques, such as the Johansen procedure, would not have proved useful, all gaps (output, velocity and foreign price) being stationary series.
Kool and Tatom (1994) encounter a similar problem in the case of Denmark: the ADF test cannot reject the hypothesis of a unit root for the residuals of the foreign price gap but this is introduced as an explanatory variable of inflation anyway accompanied by a word of caution.
Model reduction tests involve a combination of tests and comparisons of the residual sum of squares, standard error, and Schwarz Bayesian Criterion.