A Network Model of Multilateral Equilibrium Exchange Rates

Abstract

The objective of the paper is to propose a new network model of multilateral equilibrium exchange rates based on network theory. The model introduces a topological component into the exchange rate analysis, consistently taking into account simultaneous higher-order interactions among all currencies. The article argues that the evolution of nominal exchange rates can be modeled on a network, where the nodes represent individual currencies and the links among them represent weighted returns on a hypothetical investment in each currency. For the purposes of this article, a multilateral exchange rate network is represented by multilateral dependent changes in bilateral exchange rates. The currency demand indicator (CDI), an elementary cell of the network model, is defined as weighted log-returns on each currency. The CDI provides a useful proxy for demand for each currency from other currencies and reflects all underlying balance of payments flows. The model identifies the stationary position of the exchange rate network, i.e. the episodes of minimal temporal variety of the CDI, when weighted returns on the links are close to zero. The stationary position of the exchange rate network points to the equilibrium levels of bilateral exchange rates for each currency pair. The model applies mainly to currencies with floating exchange rate regimes, although useful information can also be obtained for currencies with pegged exchange rates. For illustration, the model is applied to bilateral daily 1995-2016 exchange rates among130 currencies sourced from the Thomson Reuters Datastream.