Model Of Exchange Rate Determination Research Articles

Exchange rates and fundamentals: Forecasting with long maturity forward rates

We show that in a popular model of exchange rate determination, the unobserved expected future exchange rate can be substituted with the observed forward exchange rate. This allows the derivation of a new error-correction forecasting model, which approximates the gap between the fundamental equilibrium exchange rate and the actual exchange rate with the long-maturity forward exchange rate. Our out-of-sample forecasting results for major currencies are unprecedented. The forecasting model is simple, easy to replicate, and the data we use are available in real time and not subject to revisions.

Liquidity yield and exchange rate predictability

In this paper, we extend the Taylor rule model of exchange rate determination by incorporating the liquidity yield on government bonds, and investigate exchange rate predictability from the augmented Taylor rule model. We find that the liquidity yield on government bonds delivers additional predictive power to future exchange rate movements beyond the model with Taylor rule fundamentals, using both in-sample and out-of-sample tests. In particular, the augmented model with liquidity yield exhibits superior predictive power after the currency swap market frictions are controlled.

Does Purchasing Power Parity Hold Between Asian Economies Before and After the Financial Crisis? Evidence from the Time-Series Model

In exchange rate determination models, the purchasing power parity (PPP) acts as a fundamental theory, which provides the basis for exchange rate determination across countries respectively. The main objective of this study is to investigate if there exists long-run purchasing power parity in the long run between the Asian economies and developed economies. This will help to understand the long-run exchange rate determination in these countries and helps to make effective monetary policies. This study tests the long-run PPP relationships between Asian economies (China, Japan, Singapore) with the UK and the US respectively. It is important to observe whether PPP holds between Asian economies and the economies of the UK and US by using time-series analysis respectively. Johansen Cointegration test is used to examine the relative PPP among these countries on full sample and sub-samples before and after the global financial crisis respectively. In full sample and subsamples, the Cointegration results show that PPP holds Asian economies (China, Japan, and Singapore) with the UK and the US respectively. This study finds significant evidence to accept that PPP holds which implies that the domestic prices of Asian economies are influenced by the US and UK prices and it explains a significant amount of variation in their domestic prices and inflation.

Oil Rents and Exchange Rate in Oil-Exporting Countries: Re-Assessment of the Monetary Model of Exchange Rate Determination

Oil Rents and Exchange Rate in Oil-Exporting Countries: Re-Assessment of the Monetary Model of Exchange Rate Determination

Exchange Rate Disconnect in General Equilibrium

We propose a dynamic general equilibrium model of exchange rate determination that accounts for all major exchange rate puzzles, including Meese-Rogoff, Backus-Smith, purchasing power parity, and uncovered interest rate parity puzzles. We build on a standard international real business cycle model with home bias in consumption, augmented with shocks in the financial market that result in a volatile near-martingale behavior of exchange rates and ensure their empirically relevant comovement with macroeconomic variables, both nominal and real. Combining financial shocks with conventional productivity and monetary shocks allows the model to reproduce the exchange rate disconnect properties without compromising the fit of the business cycle moments.

Fiscal Cyclicality and Currency Risk Premia

Abstract I develop a model of real exchange rate determination that attributes a central role to the intertemporal government budget condition, which equates the market value of government debt to the present value of government surpluses. To enforce this equilibrium condition in the presence of nominal rigidities, the real exchange rate has to adjust in response to shocks to government surpluses. The model predicts that fiscal shocks account for real exchange rate movements, and the factor structure in fiscal shocks aligns with the factor structure in currency returns. Both predictions are confirmed in the sample of developed countries.

경제정책 불확실성 지수가 환율결정에 주는 영향분석

The free-floating exchange rate system was applied in South Korea after the 1997 Asian financial crisis. Since then, a lot of studies on exchange rate determination were conducted based on the monetary approach. However, after the 2008 global financial crisis, the economic policies of major countries had a greater impact on financial markets, but fewer studies were published on how the exogenous changes in economic policies affect the foreign exchange market of small open economies. Based on the related literature, we selected explanatory variables such as money supply, income, interest rate, terms of trade, and capital account, and then constructed a Won/Dollar exchange rate determination model by adding Economic Policy Uncertainty(EPU) indexes Baker, Bloom, and Davis(2016) devised as supplementary variables. The empirical analysis period is from October 2000 to December 2020, and regression analysis was performed using both a linear multiple regression model a non-linear VECM model. Monetary model-related variables, such as money supply and interest rate were proved to be more significant factors before the financial crisis. On the other hand, the influence of the EPU indexes was greater after the financial crisis and in particular, the Korea EPU index and Japan EPU index had a significant impact.

Exchange Rate in Ethiopia: A Graphical Analysis of Trends and Determinates

The question of exchange rate determination has been just in the core of academic debates. Even though many exchange rate determination models and their amendments have been developed, scholars/writers still cannot agree on which model best describes behavior of exchange rate. Exchange rate is an essential element of the macro- economic variables that needs to be address in Ethiopia since the Ethiopian birr consistently losing its value and it is necessary to know the factors affecting, in order to analysis the determinate factors, to see which of those possible factors need to be care to control the exchange rate. The objective of this paper was to analysis the relationship among the level of exchange rate in Ethiopia and selected main determinant factors argued in both flow and stock theory of exchange rate determination. The analysis was carried out by detail reviewing the prior researchers work on the area and using correlation and trend analysis for the 18 (2000-2017 G.C) year data obtained from National bank of Ethiopia Quarterly Bulletin. The result shows that nominal exchange rate of Ethiopia relates positively with government spending, broad money supply, inflation level, economic growth, interest rate and negatively with term of trade balance and current account balance. Moreover, it revealed that, government spending; broad money supply and nominal interest rate are the major determinants than inflation, economic growth term of trade balance, and current account balance. Keywords: Exchange rate, balance of payment theory, Monetary theory, Ethiopia DOI: 10.7176/JESD/12-3-05 Publication date: February 28 th 2021

The Role of Beliefs in Asset Prices: Evidence from Exchange Rates

A long-standing challenge in the asset pricing literature is to understand why asset prices sometimes underreact and sometimes overreact to news. We seek to address this challenge in the context of currency markets. We construct a model of exchange rate determination disciplined by survey data, where short-lived investors each (1) receive noisy private signals about the future path of interest rate differentials between the US and other countries and (2) overestimate the persistence of interest rate differentials. The model is able to qualitatively and quantitatively match patterns of underreaction and overreaction of exchange rates in response to news. The model also matches the failure of uncovered interest rate parity (UIP), capturing the return predictability of interest rate differentials for the returns to borrowing in USD and lending in foreign currency, as well as the fact that this return predictability is declining in the maturity of bonds used to borrow and lend. Finally, we use the model to help understand the reversal of the failure of UIP in recent years, the role of higher-order uncertainty, and the persistence of subjective beliefs. Our results highlight the important role that investors' beliefs may play in asset price behavior.

Dynamics of Relationship Between Macroeconomic Fundamentals and Exchange Rate: A Comparison of Advanced and Least Developed Countries

The exploration of relationship between macroeconomic fundamentals and exchange rate is needed in the perspective of economic structure of the economies. The focus of current study is to inquire the dynamics of exchange rate behavior in response to macroeconomic fundamentals for advanced and least developed countries. The Pooled Mean Group regression based on panel ARDL and Panel Granger Causality Test are employed on annual panel data sets for the time period 1995-2015. The results evidence a strong relationship between macroeconomic fundamentals and exchange rate volatility in advanced countries and a moderate relationship in least developed countries. The exchange rate level has been observed entirely governed by the selected set of macroeconomic fundamentals in both group of countries. The results validate the fundamental macroeconomic models of exchange rate determination as the macroeconomic fundamental indicators play an important role in the determination of exchange rate volatility as well as exchange rate level. It may be concluded that the relationship between fundamental macroeconomic indicators and exchange rate behavior is sensitive to the economic structure of the countries.

Assessing Monetary Model of Exchange Rate Determination: Case of Indonesia

The main purpose of this paper is to assess the exchange rate determination in Indonesia after the Asian financial crisis. We use the Monetary Model to assess the prediction of the Indonesian Rupiah against the United States Dollar and other currencies of the largest trade partners of Indonesia. The models are the Flexible Price Monetary Model and the Sticky Price Monetary Model. We estimate short-run and long-run relationships using the Error Correction Model. The Monetary Model can explain partially the exchange rate variations, but the signs of money, income, and fiscal balance are not as expected. The causality may run from the exchange rate to money and price level.

The news effects on exchange rate returns and volatility: Evidence from Pakistan

AbstractThis article explores the effects of macroeconomic news on Pak rupee's exchange rates. For this purpose, it employs GARCH models by using real‐time data on macroeconomic news and exchange rates. The results exhibit that daily Pak rupee exchange rates dynamics are linked to macroeconomic fundamentals. Both foreign and domestic macroeconomic news announcements significantly affect Pak rupee exchange rates. The exchange rate returns and volatility of Pak rupee immediately adjust to most of the foreign and domestic macroeconomic news. Most of the US and PAK domestic macroeconomic news immediately affect PKR/USD exchange rates as compared to the effect of other foreign and domestic macroeconomic news on other Pak rupee exchange rates. Finally, the article shows that Pak rupee exchange rate returns and their volatilities are responsive to foreign and domestic macroeconomic news announcements with different magnitudes for all the currency pairs. These findings suggest that the behaviour of PAK rupee exchange rate appears to be consistent with the models of exchange rate determination and the monetary authority's reaction function.

Testing monetary exchange rate models with the Westerlund panel cointegration test

Time series testing of long-run monetary models of exchange rate determination in most cases fails to support the conjectures of the theory. The empirical literature increasingly uses the panel technique when testing monetary exchange rate models because the power of the panel unit root and panel cointegration tests seems higher than the pure time series tests. In this paper we examine the validity of the monetary exchange rate models over the period 1996Q1-2011Q4 for US dollar exchange rates of 15 OECD countries using Westerlund’s 2007 panel cointegration tests. We found moderate empirical support for monetary exchange rate models.

A System Dynamics Model Of Exchange Rate Determination And Forecasting

Objective: The objective of this paper is to develop a model of exchange rate determination and forecasting to provide reasonable forecasts for the exchange rate to facilitate long-term investments. Design: The study develops the model using the system dynamics method. Grounded on the fundamental theories, the model incorporates nonlinear feedback relationships of interest rate, inflation, per capita income, terms of trade, and oil prices with the exchange rate. Findings: The simulation results indicate the robustness of the model to mimic not only the long term past behavior of the exchange rate but also its ability to provide a reliable long-term forecast for the exchange rate. The model is portable and applies to any oil-exporting country after calibration. Policy Implications: The study has practical implications for individuals, businesses, and the Government because they are all influenced by the exchange rate movements. Specifically, this model provides a useful tool for long term strategic financial planning of oil firms. Originality: The study develops a model for exchange rate accounting for nonlinear feedback relationships among the variables.

Determinants of Exchange Rate in Ethiopia: A Graphical Approach

The question of exchange rate determination has been just in the core of academic debates. Even though many exchange rate determination models and their amendments have been developed, scholars/writers still cannot agree on which model best describes behavior of exchange rate. Exchange rate is an essential element of the macro- economic variables that needs to be address in Ethiopia since the Ethiopian birr consistently losing its value and it is necessary to know the factors affecting, in order to analysis the determinate factors, to see which of those possible factors need to be care to control the exchange rate. The objective of this paper was to analysis the relationship among the level of exchange rate in Ethiopia and selected main determinant factors argued in both flow and stock theory of exchange rate determination. The analysis was carried out by detail reviewing the prior researchers work on the area and using correlation and trend analysis for the 18 (2000-2017 G.C) year data obtained from National bank of Ethiopia Quarterly Bulletin. The result shows that nominal exchange rate of Ethiopia relates positively with government spending, broad money supply, inflation level, economic growth, interest rate and negatively with term of trade balance and current account balance. Moreover, it revealed that, government spending; broad money supply and nominal interest rate are the major determinants than inflation, economic growth term of trade balance, and current account balance. Indeed, it is concluded as there is some theoretical and empirical deviations on the result of this study, may be due to the effect of some other missed variables (gov’t intervention level, political risk, cultural sentiment. Keywords: Exchange rate, balance of payment theory, Monetary theory, Ethiopia DOI: 10.7176/IAGS/68-01 Publication date: July 31 st 2020

The Dynamics of the Exchange Rate and Extension of Monetary Trilemma

Simultaneous making policy of interest rates, exchange rates and capital accounts can be extended to trilemma theory, contrary to its earlier theories, provided that the imbalances of the private sector, the government and the capital account adjusted through the policy variables such as the government expenditures, the interest rates on domestic deposits, the interest rates on domestic loans, effective exchange rates, foreign prices and foreign interest rates. On the other hand, the components of the extension of trilemma theory in the form of internal and external imbalances affect the exchange rate. In other words, if the real sector markets of the economy are not cleared through the aforementioned trilemma components, and policy variables, internal and external imbalances will be affected by opposite direction of net domestic assets (ΔNDA) and net foreign assets (ΔNFA) of the banking system. This is in accordance with the fundamental principles of the monetary approach balance of payments and exchange rate. Policy variables do not put pressure on the unofficial exchange rate as long as they have the same effect on the net changes in the domestic and foreign assets of the banking system. The purpose of this study is to consider the effect of internal and external imbalances on exchange rate through the simultaneous equations system, generating impulses in policy variables, and examining reactions in Iranian economy. In this paper, the monetary exchange rate determination model is analyzed and examined by using the extension of trilemma theory for macroeconomic data of Iran in the form of internal and external imbalances. The results of this study suggest that policy variables can stabilize the unofficial exchange rate (with other conditions being constant) through trading off internal and external imbalances. Thus, the economic policymaker can, while independently policing interest rates, capital accounts and government expenditures and other policy variables in this research, maintain exchange rate stability as a strategic variable and anchor the general level of prices.

Liquidity Yield and Exchange Rate Predictability

In this paper, we extend the Taylor rule model of exchange rate determination by incorporating the liquidity yield on government bonds and investigate exchange rate predictability. We find that the liquidity yield on government bonds delivers additional predictive power to future exchange rate movements beyond the model with Taylor rule fundamentals, using both in-sample and out-of-sample tests. In particular, the model with liquidity yield exhibits superior predictive power after the currency swap market frictions are controlled.

A re-examination of the exchange rate overshooting hypothesis: Evidence from Zambia

2Dornbusch’s exchange rate overshooting hypothesis has guided monetary policy conduct for many years, despite the fact that empirical evidence on its validity is mixed. This study re-examines the validity of the overshooting hypothesis by using the autoregressive distributed lag (ARDL) procedure. Specifically, the study investigates whether the overshooting hypothesis holds for the United States dollar/Zambian kwacha (USD-ZMK) exchange rate. In addition, the study tests whether there is a long-run equilibrium relationship between the USD-ZMK exchange rate and relevant macroeconomic fundamentals. Using monthly nominal USD/ZMK exchange rates and monetary fundamentals data from January 2000 to December 2012, the study finds no evidence of exchange rate overshooting. The results also show that there is no long-run equilibrium relationship between the exchange rate and the differentials of macroeconomic fundamentals. The implication is that macroeconomic fundamentals are insignificant in determining the exchange rate fluctuations in the long run. This finding is inconsistent with the monetary model of exchange rate determination, which asserts that there is a long-run relationship between the exchange rate and macroeconomic fundamentals.

Exchange Rate Disconnect in General Equilibrium

We propose a dynamic general equilibrium model of exchange rate determination, which simultaneously accounts for all major exchange rate puzzles. This includes the Meese-Rogoff disconnect puzzle, the PPP puzzle, the terms-of-trade puzzle, the Backus-Smith puzzle, and the UIP puzzle. We build on a standard international real business cycle model augmented with a financial sector with noise traders and risk-averse intermediaries, which results in equilibrium UIP deviations due to limits to arbitrage. We show that financial UIP shocks result in persistent near-martingale processes for exchange rates and ensure empirically relevant comovement properties between exchange rates and macro variables, including excess exchange-rate volatility relative to aggregate consumption and output. In contrast, conventional productivity and monetary shocks, while successful in explaining the international business cycle comovement, result in counterfactual exchange rate dynamics with insufficient volatility. As a result, when combined together, the two sets of shocks reproduce both the exchange rate disconnect behavior and the empirical business cycle properties. The transmission mechanism relies on a conventional Taylor rule, home bias in consumption, and muted pass-through of exchange rates into prices and quantities due to pricing to market and weak substitutability between home and foreign goods. Nominal rigidities improve somewhat the quantitative performance of the model, yet are not necessary for the exchange rate disconnect, as monetary shocks are not the key drivers of the exchange rate.

Forecasting the exchange rate using nonlinear Taylor rule based models

This research utilises a non-linear Smooth Transition Regression (STR) approach to modelling and forecasting the exchange rate, based on the Taylor rule model of exchange rate determination. The separate literatures on exchange rate models and the Taylor rule have already shown that the non-linear specification can outperform the equivalent linear one. In addition the Taylor rule based exchange rate model used here has been augmented with a wealth effect to reflect the increasing importance of the asset markets in monetary policy. Using STR models, the results offer evidence of non-linearity in the variables used and that the interest rate differential is the most appropriate transition variable. We conduct the conventional out-of-sample forecasting performance test, which indicates that the non-linear models outperform their linear equivalents as well as the non-linear UIP model and random walk.