Effect of Oil Prices on Exchange Rate Movements in Korea and Japan Using Markov Regime-Switching Models

Suyi Kim,So-Yeun Kim,Kyungmee Choi

doi:10.3390/en13174402

Abstract

We examined the effects of oil prices along with fundamental economic variables on exchange rate movements in the Korean and Japanese foreign exchange markets, using two-regime Markov Regime Switching Models (MRSMs) over the period from January 1991 to March 2019. We selected the best MRSMs explaining their exchange rate movements using the Maximum Log-Likelihood and Akaike Information Criteria, and analyze effects of oil prices on their exchange rates based on the selected best MRSMs. We consider two regimes, regime 1 with high-volatility and regime 2 with low-volatility. In Korea, two apparent regimes are observed, and unstable regime 1 consists of two distinct prolonged periods, the 1997 Asian Financial Crisis and the 2008 Global Financial Crisis. Meanwhile in Japan, no evident prolonged regimes are observed. Rather, the two regimes occasionally alternate. Oil prices influence exchange rate movements in regime 2 with low-volatility in Korea, while they do not influence exchange rate movements in either regimes in Japan. The Japanese foreign exchange market is more resistant to external oil price shocks because the Japanese industry and economy has less dependence on oil than Korea.

Highlights

While the share of oil in the world’s energy supply is slowly decreasing, oil is still the largest primary energy source
We extended Kim et al [14] in order to examine the impact of oil prices on exchange rates against the US dollar, by taking account of trade balances in addition to interest rates, consumer price index (CPI), and industrial production index (IPI) as an influencing factor on the exchange rates in Korea and Japan
We investigate how the impact of oil prices on exchange rates varies in Korea and Japan, using Markov Regime Switching Models (MRSMs)

Summary

Introduction

While the share of oil in the world’s energy supply is slowly decreasing, oil is still the largest primary energy source. According to the International Energy Agency (IEA, 2019) [1], though the share of oil in the world total primary energy supply (TPES) fell from 44% to 32% between 1971 and 2017, it was still the dominant fuel and accounted for 32% in world TPES in 2017, followed by 27% coal, and 22% natural gas. Despite the changes in the global energy structure, oil prices are steadily increasing, serving as price measurement of other energy sources, such as natural gas and coal. As a result of fluctuations in oil prices, the volatility of the national economy has been growing in countries largely dependent on oil imports. Volatility of exchange rates is strongly related to volatility of oil prices, which has been an important research topic in energy economy

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