The Macroeconomics of Exchange-rate and Price-level Interactions: Empirical Evidence for West Germany

This paper studies the evidence on the conditional covariances between the German wholesale price level and the Deutsche mark exchange rate in the short run and in the long run. I rely both on an unrestricted time-series model, and on a structural Mussa-Dornbusch model. The results from unrestricted estimates indicate that the volatility of change. in the nominal exchange rate much exceed the volatility of the inflation rate both in the short run and in the long run. This implies a very high correlation between changes in the nominal and real exchange rate, and a correlation between the inflation rate and changes in the exchange rate that never exceeds .4--with 959 probability. The results from the structural estimates and sensitivity analysis indicate that perfect price flexibility is strongly rejected, and chat the model tends to make sticky prices play a crucial role in explaining the evidence. Since the overidentifying restrictions implied by the structural model are rejected, I conclude that we still do not have a fully satisfactory explanation of observed extreme sluggishness of aggregate price levels.