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Vol. 76, No. 3
Posted 1994-05-01

The P-Star Model in Five Small Economies

by Clemens J.M. Kool and John A. Tatom

A nation’s exchange rate regime affects the link between its monetary aggregates and its general level of prices, according to Clemens J.M. Kool and John A. Tatom. They explain an empirical specification of a quantity theory of money called the P-star model, which indicates that a country's price level depends principally on its own money stock. This theory, however, applies only to a closed economy or one with a flexible exchange rate. In contrast, they argue, a small open economy which pegs the value of its currency to another country’s currency also pegs its prices to that country’s money stock. Kool and Tatom explain how the P-star model can be adapted for use in small open economies with fixed exchange rates. They test their open-economy P-star model on five countries bordering Germany: Austria, Belgium, Denmark, the Netherlands and Switzerland. These countries have pegged their currencies to the deutsche mark to varying degrees since the breakdown of the Bretton Woods agreement. Kool and Tatom’s evidence supports the theoretical model, especially the principal hypothesis that, to the extent a country pegs the value of its currency to the German mark, its own inflationary developments are determined by monetary conditions in German.





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