Foreign Money Demand Estimation (an empirical analysis of exchange rates)

Abstract

In this paper we obtain the equation of money demand in the presence of currency substitution. It is shown, that despite penalties to foreign currency use, agents continue to use it for transactions. The problem is solved by using dynamic optimization technique which shows that the main factor influencing the demand for foreign currency is expected depreciation. To forecast the depreciation rate models with partial integration (long memory processes) have been applied. Using Armenian data an empirical analysis has been conducted which has shown that the power of forecasting of the models with partial integration is higher than of random walk. Combining the theoretical and empirical model one can forecast the rate of depreciation and estimate the change in the volume of foreign currency.