SMITH (1999) tests a regression of changes in the real domestic price of good i – defined as
Pi =epic / π, where e is the nominal exchange rate, Pie is the external price of good i and π is
inflation – against the exchange rate. According to the model developed, the value of the
coefficient will tell whether the exchange rate variance will increase or reduce the volatility of real
domestic prices. Results show that an increase in exchange rate volatility causes a drop in inflation
volatility in about 31% of times. Another indicator proposed by the authors is the value of the
equation’s R2, which shows how much of the variance in the real domestic price is explained by
exchange rate movements.