Exchange Rate Shocks Research Articles

Exchange rate risks in a small open economy

PurposeThis study aims to analyze exchange rate risks and the choice of exchange rate policies in a small open economy indebted in foreign currency, incorporating the financial accelerator mechanism.Design/methodology/approachTo examine discussions on the fear of floating, this study develops a dynamic stochastic general equilibrium model in which a small open economy model has an open economy financial accelerator mechanism as the external borrowing restriction. The author then compares and analyzes the macroeconomic dynamics in response to an exchange rate shock under different exchange rate systems.FindingsThe most interesting finding is that the currency peg for a foreign currency used in borrowing is more efficient than the trade-weighted currency basket policy, regardless of trade openness or trade share.Practical implicationsThe result implies that in discussions on the fear of floating, more attention needs to be paid to exchange rate risks in finance. It also suggests that exchange rate policy used to mitigate exchange rate risks in finance stabilizes macroeconomic volatility more efficiently.Originality/valueThe paper provides an answer to the question: which is the more serious problem in the fear of floating and to what would the regime be anchored.

Inflationary shocks and real output growth in nine Muslim-majority countries: Implications for Islamic banking and finance

Low and stable inflation is important for maintaining the viability of Islamic banking and finance within a dual banking system. Inflationary shocks when transmitted to real output growth cause a shift of investment to fixed return products as a hedge against the uncertainty of returns on equity investment under Islamic profit-loss sharing contracts. This study examines the transmission of inflationary shocks to the real economy for nine Muslim-majority countries (Bahrain, Bangladesh, Egypt, Indonesia, Iran, Malaysia, Pakistan, Saudi Arabia, and Turkey) that have introduced Islamic banking, all except Iran within dual-banking systems. A structural vector autoregressive (SVAR) framework is deployed to understand macroeconomic relationships using annual data from the late 1970s to 2014. The key finding is that inflationary shocks affect real interest and exchange rates which in turn impact real output growth. The paper argues that the absorption of inflationary shocks in real interest and exchange rates is the outcome of rigidities in nominal interest and exchange rates within repressed financial systems. Policy regimes that allow for greater adjustment in nominal interest and exchange rates under a deregulated financial system would offer better shock absorption capacity which would lead to less volatility in inflation, real interest and exchange rates, and real output growth. The resulting more stable macroeconomic environment would be more conducive to the development of an Islamic financial sector that would promote economic growth.

The RMB Debate: Empirical Analysis on the Effects of Exchange Rate Shocks in China and Japan

AbstractFor a better understanding of the ongoing debates on the RMB, this paper investigates the effects of exchange rate shocks on output and the current account for China and Japan. We use structural vector auto‐regression models and find that yen appreciation reduces current account surpluses while having no strong effect on output in Japan. RMB appreciation, on the other hand, has an insignificant effect on the current account, although it tends to reduce output in China. For China, dollar pricing with vertical trade integration seems responsible for the insignificant effect on the current account.

Monetary Policy Shocks and Industrial Sector Performance in South Africa

This paper employs an eight variable Structural Vector Auto regression (SVAR) model to examine how monetary policy shocks affect industrial sector performance in South Africa using monthly data from 1994:1 to 2012:12.The study finds no direct link between exchange rate and interest rate shocks and industrial output growth. A money supply shock, however, is observed to exert a significant positive impact on industrial output growth from about the eighth month. The study also reveals that the interest rate response to an unanticipated increase in the rate of inflation is insignificant, reflecting the infrequent changes of the repo rate in the country. We also find evidence of a symbiotic relationship between industrial output growth and other sectors of the economy that form components of aggregate output. The study further demonstrates that monetary authorities have very limited control over industrial output growth using instruments of monetary policy. In addition, it is found that relatively large proportions of the variations in the rate of inflation are explained by changes in money supply, exchange rates and industrial output. We also observe that variations in exchange rates are largely explained by unexpected changes in the exchange rates themselves, which supports the Martingale Hypothesis of exchange rates.

Oil Prices, Exchange Rate and Prices for Agricultural Commodities: Empirical Evidence from Russia

In this paper, we investigate long and short-term impact of changes in oil prices and the exchange rate on prices of seven groups of agricultural products in Russia (buckwheat, grain crops, potatoes, oat, wheat, rye, barley). In this paper, Granger causality approach is applied to test long-run interlinkages with monthly data from January 1999 to October 2015. For testing the response of agricultural prices to sudden shocks in oil prices and exchange rate in the short run, we use impulse-response techniques. The results of impulse response analysis show that agricultural prices are not particularly sensitive to changes in oil prices and the exchange rate of Russian ruble in the short term, except for imported commodities. In the long run, Granger causal relationship between agricultural prices and oil prices is missing, and with exchange rate is observed only in case of imported agricultural goods.

Oil Prices, Exchange Rate and Prices for Agricultural Commodities: Empirical Evidence from Russia

In this paper, we investigate long and short-term impact of changes in oil prices and the exchange rate on prices of seven groups of agricultural products in Russia (buckwheat, grain crops, potatoes, oat, wheat, rye, barley). In this paper, Granger causality approach is applied to test long-run interlinkages with monthly data from January 1999 to October 2015. For testing the response of agricultural prices to sudden shocks in oil prices and exchange rate in the short run, we use impulse-response techniques. The results of impulse response analysis show that agricultural prices are not particularly sensitive to changes in oil prices and the exchange rate of Russian ruble in the short term, except for imported commodities. In the long run, Granger causal relationship between agricultural prices and oil prices is missing, and with exchange rate is observed only in case of imported agricultural goods.

Sentiment-Driven Asymmetries in Romanian Monetary Policy Transmission

A threshold Bayesian VAR model is applied to study nonlinearities in Romania’s monetary policy transmission mechanism, with the transition variable represented by the Economic Sentiment Indicator. The model identifies four major episodes with respect to the confidence stance during the 1997–2014 period: the two low-confidence episodes are related, respectively, to the Asian crisis (late 1990s) and the Great Recession (2009–2013 observations), while the two high-confidence episodes consist of the economic boom of 2000–2008 and the current restored sentiment stage. Output and prices react differently to monetary policy and to exchange-rate shocks during the two regimes. A counterfactual experiment proves that the heterogeneities are driven by changes to the overall macroeconomic transmission framework, as well as to the central bank’s reaction function. An alternative specification with industry confidence rather than aggregate economy confidence suggests that, following the recent crisis, firms’ sentiment recovered much faster than that of consumers and the services sector.

Raising an Inflation Target: The Japanese Experience with Abenomics

This paper draws from Japan’s recent monetary experiment to examine the effects of an increase in the inflation target during a liquidity trap. We review Japanese data and examine through a VAR model how macroeconomic variables respond to an identified inflation target shock. We apply these findings to calibrate the effect of a shock to the inflation target in a new-Keynesian DSGE model of the Japanese economy. We argue that imperfect observability of the inflation target and a separate exchange rate shock are needed to successfully account for the behavior of nominal and real variables in Japan since late 2012. Our analysis indicates that Japan has made some progress towards overcoming deflation, but further measures are needed to raise inflation to 2 percent in a stable manner.

Korean Current Account Surplus and the Transmission of the Won-Dollar Exchange Rate

This paper empirically investigates the effects of exchange rate shocks on the variables of the primary interests, such as trade balance and current account, using the Korean data. The result shows that the effect of the won-dollar exchange rate on the current account is weak. This is because the effect of the won-dollar exchange rate on exports and imports are similar. We also examine the effect of the won-dollar exchange rate shock on Korea’s trade balance with major trading partners such as the US, China, Japan, and the European Union, respectively. The results show that the responses of the Korea-Japan and Korea-European Union trade accounts are weak and not statistically significant; but those from the Korea-US trade account and the Korea-China trade account are statistically significant.

Firm Dynamics in Retail Trade: The Response of Canadian Retailers to Exchange Rate Shocks

AbstractWe use comprehensive firm‐level data to estimate the responses of heterogeneous Canadian retail firms to real exchange rate movements. Our analysis focuses on a period characterized by large fluctuations in the Canadian dollar, providing an opportunity to quantify both intensive and extensive margin responses in retail industries to real exchange rate shocks and to examine how those responses differ across firms, locations, and sub‐industries. Our results indicate that a real Canadian currency appreciation significantly reduces a retailer's sales, employment, and profits. The strength of this negative effect is decreasing in the distance of a retailer from the US‐Canada border. We do not find evidence of a strong relationship between real exchange rate movements and the number of operating firms nor the probability of firm survival. These findings are consistent with the view that a real Canadian dollar appreciation increases cross‐border shopping by Canadians, resulting in a negative demand shock for Canadian retailers, and the dominant response by firms to such a shock is through the intensive margin.

Raising an inflation target: The Japanese experience with Abenomics

This paper draws from Japan׳s recent monetary experiment to examine the effects of an increase in the inflation target during a liquidity trap. We review Japanese data and examine through a VAR model how macroeconomic variables respond to an identified inflation target shock. We apply these findings to calibrate the effect of a shock to the inflation target in a new-Keynesian DSGE model of the Japanese economy. We argue that imperfect observability of the inflation target and a separate exchange rate shock are needed to successfully account for the behavior of nominal and real variables in Japan since late 2012. Our analysis indicates that Japan has made some progress towards overcoming deflation, but further measures are needed to raise inflation to 2 percent in a stable manner.

EVOLUTION OF MONETARY POLICY TRANSMISSION MECHANISM IN MALAWI: A TVP-VAR APPROACH

This paper investigates the evolution of monetary transmission mechanism in Malawi between 1981 and 2010 using a time varying parameter vector autoregressive (TVP-VAR) model with stochastic volatility. We evaluate how the responses of real output and general price level to bank rate, exchange rate and credit shocks have changed over timesince Malawi adopted financial reforms in 1980s. The paper finds that inflation, real output and exchange rate responses to monetary policy shocks changed over the period under review. Importantly, beginning mid-2000, the monetary policy transmission performed consistently with predictions of economic theory and there is no evidence of a price puzzle as found in the previous literature on Malawi. However, the statistical significance of the private credit supply remains weak and this calls for more financial reforms targeting the credit market which can contribute to monetary transmission and promote further economic growth in Malawi. JEL classification: C49 D12 D91 E21 E44

The Beliefs of Central Bankers About Inflation and the Business Cycle—and Some Reasons to Question the Faith

Although the U.S. Fed has recently created trillions of dollars through its purchases of Treasury Bonds and other securities, this has not had the usual inflationary consequences. The lesson from this experience is that inflation results from an increase in the supply of money over and above the demand to hold money. And this in turn implies that to be effective, any forecasting model of inflation, whether run inside or outside the Fed, must be provided with accurate estimates of the demand for as well as the supply of money, which is a formidable task given the extraordinary stock of excess over required cash reserves now held by U.S. banks.Unlike the approach of the U.S. Fed, the monetary policy of South Africa's Reserve Bank does not appear to distinguish between the more or less temporary effects of supply‐side shocks on inflation, such as those stemming from a weakening of the currency, from changes in the relatively permanent demand‐side forces that drive prices higher or lower. Instead of ignoring such supply‐side shocks, as Fed Chair Yellen has counselled the Fed to do, the Resbank has reacted to higher prices of whatever provenance in the same way, raising or lowering interest rates accordingly. This has made its policies highly pro‐cyclical in an economy subject to dramatic exchange rate shocks that are independent of monetary policy settings.But if the U.S. Fed has been right to ignore the effects of its policies on changes in the U.S. dollar, it has introduced another source of uncertainty. By postulating that only unexpected inflation is capable of stimulating economic activity, the Fed model makes a strong case for the benefits of highly consistent and predictable, central bank‐influenced expectations of low inflation in maintaining economic growth and employment. But for all the wisdom of this policy, the Fed also appears to persist in believing in its own ability to engineer inflation surprises, with the intent of managing the business cycle. Experience tells us that such attempts at fine‐tuning are almost certain to prove not only futile, but also incompatible with the Fed's own goals of predictable policy actions and reactions. These contradictions about the role that expectations and Fed‐watching play in the economy lead toward a different policy prescription: namely, reliance upon monetary policy rules rather than policy discretion to minimize inflation and other surprises.

Price setting & price stickiness: A developing economy perspective

We study price setting in Pakistan using 1189 structured interviews of managers organized by the State Bank of Pakistan–Pakistan’s Central Bank. We find that on an annual basis the incidence of price adjustment is three times higher than in developed countries. The remaining price rigidity is explained by the existence of firms’ interactions with the informal sector, strategic interactions with other firms and the uncertainty about temporariness of shocks. The exchange rate and cost-push shocks matter more and are incorporated faster into prices than financial cost and demand-pull shocks. The roughly bimodal nature of price reviewing strategies together with a high frequency of price adjustment imply that monetary policy will carry low potency. Time-dependent price reviewing strategies tend to dominate state-dependent strategies, but the ratio of price reviews to actual adjustment is too high and inconsistent with the moderate levels of inflation experienced by Pakistan.

Long-Run Effects of Macro Shocks on the Korean Stock Market: A Structural VAR Approach

This paper examines the long-run effect of major macroeconomic shocks, using the structural vector autoregression (SVAR) approach, on stock prices for the Korean stock market, one of the leading emerging markets. Novel features of the modeling is to expand the dimension of the bivariate SVAR model of Blanchard and Quah (1989) and of Hess and Lee (1999) by including stock market shocks in addition to the pre-identified supply and demand shocks. Moreover, our three-variable SVAR model is further generalized to a five-variable SVAR, augmenting interest rate shocks and foreign exchange rate shocks. The model is estimated using monthly Korean market data from January 2003 to September 2015, and further estimated with two sub-samples using the recent global financial crisis period and non-crisis period. The estimation results using a three-variable model show that stock returns have a negative relation with demand shocks and a permanent positive relation with supply shocks. Risk premium shocks show a negative relation with inflation and a positive relation with real output growth. Interestingly, the subsample results indicate that the market fluctuations during the global financial crisis period have relatively little effect on the Korean stock market and its macro variables. With the five-variable model estimation, a ‘price puzzle’ is documented with evidence of a positive correlation between inflation and the interest rate shock. A positive correlation is also observed between inflation and the supply shocks in the long run. Lastly the forecast error variance decomposition indicates that the monetary policy change is the leading determinant of the long-run level of stock prices in the Korean stock market. These findings suggest that the recent expansionary monetary policy should be cautiously implemented in accordance with inflation movement.

The Speed of Exchange Rate Pass-Through

On January 15, 2015, the Swiss National Bank terminated its minimum exchange rate policy of one euro against 1.2 Swiss francs. This policy shift resulted in a sharp, unanticipated and permanent appreciation of the Swiss franc by more than 11% against the euro. We analyze the exchange rate pass-through into import unit values of this shock at the daily frequency using Swiss transaction-level trade data. Our key findings are twofold. First, for goods invoiced in euro the pass-through is immediate and complete. This finding is consistent with no systematic nominal price adjustment in this subset of goods. Second, for goods invoiced in Swiss francs the pass-through is partial and very fast: it starts on the second working day after the exchange rate shock and reaches the medium-run pass-through after eight working days on average. We interpret the latter finding as evidence that nominal rigidities unravelled quickly in the face of a large exchange rate shock.

Understanding the Sources of Exchange Rate Fluctuation in Sudan

This paper examines the sources of real exchange rate fluctuations in Sudan using Structure Vector Autoregressive technique, over the period 1979–2010. The analysis has focused on the impact of three macroeconomics shocks on fluctuations of real exchange rate, namely, supply, real demand and nominal shocks. The result shows that the real demand shocks play a significant role in explaining the variations in real exchange rate. This implies that the real demand factors such as, government spending and money supply are the major sources of depreciation of real exchange rate. By contrast, supply shocks and nominal shocks have small impact of real exchange rate.

The Effect of Exchange Rate Changes on Consumer Prices in Nigeria: Evidence from VECM Model

The continuous adoption of trade openness policies and floating exchange rates regime by developing countries exposed them to speculative pressures. It makes exchange rate shocks easily transferred to domestic consumer prices. That makes tremendous impacts on the domestic consumer price inflation. This paper thus examines the response of domestic consumer prices to exchange rate changes otherwise known as ‘Exchange rate pass-through’. The paper uses vector error correction (VECM) model to examine the relationship. A quarterly time series data for a period ranging from 1986Q1 to 2013Q4 for Nigeria was used. The study found a substantial but incomplete and slow pass-through of exchange rate changes to domestic prices.

World oil prices and agricultural commodity prices: The evidence from China

It is acknowledged that crude oil prices affect agricultural prices through both direct and indirect transmission schemes (i.e. exchange rate). In China, the matter of energy security may be immediately transmitted to the food security, imposing a pressure to China's macro-economy to a certain extent. This paper examines the long-run and short-run influence caused by the world crude oil prices and the RMB-dollar exchange rate on the five individual agricultural commodity prices (soybean, maize, wheat, colza oil, and japonica rice) in China. In this paper, the Granger causality approach is applied to test the long-run interrelationships with the weekly data from June 2002 to August 2013. In addition, the impulse-response analysis is utilized to study how the agricultural prices react to the sudden shocks in oil prices and exchange rate in the short term. The results reveal that the impulse response curves demonstrate that agricultural prices are not significantly affected by the abrupt changes in either oil prices or the exchange rate. Consistently, agricultural prices are neutral to the changes in oil prices in the long run while the exchange rate only Granger causes the prices of soybean. Ultimately, we present some sound reasons to explain the statistical results and propose some policy suggestions aimed at the China's food and energy security.

Exchange Rates, Employment and Labour Market Rigidity

AbstractIn this paper, we study the effect of labour market rigidity on the impact of exchange rate shocks on employment. We use a panel dataset comprising 22 manufacturing sectors across 23 OECD countries. In our econometric model, the impact of exchange rate fluctuations on sectoral employment is mediated by the degree of openness and by a measure of labour market rigidity: the OECD's employment protection legislation (EPL) index. Our results suggest that greater labour market rigidity reduces the impact of exchange rate shocks on employment. This effect is statistically significant for low‐technology sectors.