Nominal Exchange Rate Movements Research Articles

Liquidity and Exchange Rates: An Empirical Investigation

AbstractWe find strong empirical evidence that the liquidity yield on government bonds in combination with standard economic fundamentals can well account for nominal exchange rate movements. We find impressive evidence that changes in the liquidity yield are significant in explaining exchange rate changes for all the G10 countries, and we stress that the US dollar is not special in this relationship. We show how these relationships arise out of a canonical two-country New Keynesian model with liquidity returns. Additionally, we find a role for sovereign default risk and currency swap market frictions.

An Investigation into the Sources of Depreciations in Mongolian Tugrik Exchange Rate: A Structural VAR Approach

This paper empirically investigates the sources of fluctuations in real and nominal Mongolian Tugrik (MNT) exchange rates by estimating the structural vector autoregressive (SVAR) model over the period January 1994–May 2021 and decomposing the exchange rate series into stochastic components induced by real and nominal shocks under the assumption of the long-run neutrality of nominal shocks on the real exchange rate level. The empirical results show that the real MNT exchange rate movements are primarily due to the real shocks, while the nominal shocks have a major role in explaining nominal exchange rate movements in the short and long run. The nominal exchange rate shows a delayed over-shooting occurring between one and three years after a nominal shock hits the economy. The long-run effect of a monthly one standard deviation nominal shock on nominal MNT exchange rate is 2.5%, which results in a permanent divergence between real and nominal MNT exchange rate and causes non-cointegrated relation between real and nominal MNT exchange rates. The historical decomposition of forecast error indicates that the nominal shock plays a significant role in explaining the depreciation in nominal MNT exchange rate over the last three decades. Our recommendation is to stop “cash handling” policy, minimize monetary shock, and coordinate fiscal and monetary policies to avoid large nominal depreciation.

Why are countries’ asset portfolios exposed to nominal exchange rates?

Most countries hold large gross asset positions, lending in their domestic currency and borrowing in foreign currency. As a result, their balance sheets are exposed to nominal exchange rate movements. We argue that when asset markets are incomplete, this exposure provides partial insurance against shocks that move exchange rates. We demonstrate that this insurance motive can simultaneously generate realistic gross asset positions and resolve the Backus-Smith puzzle: that countries’ relative consumption and real exchange rates are negatively correlated. Local perturbation methods are inaccurate in this setting as they approximate around the wrong interest rate, even when they correctly characterize the average portfolio holdings. So to accurately solve the equilibrium portfolio problem, we extend Maliar and Maliar (2015)’s global projection method.

Contagion from the crises in the Euro-zone: where, when and why?

ABSTRACTThe prevalence of contagion between the Euro-zone countries and other European countries since the Greek crisis of 2009 is now well – known, but the factors that influence the pattern of this contagion are not well understood. We investigate this question both within Europe and beyond to the USA and Japan, using an asymmetric M-GARCH model that focuses on extreme values of the risk premia on government bonds. We compare these extreme values with news of major events and find that they are highly correlated. We find a different pattern of contagion emanating from Ireland compared to the other crisis countries of Greece, Italy, Portugal and Spain. We also examine the factors that have made countries vulnerable to contagion and find that financial factors are more important than trade ones. However, intra-Euro-zone trade has also been a significant factor between the major Euro-zone economies. There is little evidence that global factors affect contagion between EU member states, but some evidence that nominal exchange rate movements offer a degree of insulation from contagion for the non-Euro zone states.

Exchange rates, cross-border travel, and retailers: Theory and empirics

This paper provides a theoretical and empirical analysis of the effects of nominal exchange rate movements on retail firms' sales, emphasizing the role of cross-border travel by consumers. We develop a search-theoretic model of price-setting heterogeneous retailers and traveling consumers who face nominal exchange rate shocks. These shocks affect retailers on the supply side, through imported input prices, and on the demand side, via their effect on the propensity for consumers to cross the border and shop at foreign retail stores. We use Canadian retailer and traveler data from 1986 to 2007 to estimate the model. Consistent with the model, the empirical results indicate that an appreciation of the Canadian dollar substantially increases Canadians' cross border travel which has a significant negative effect on the sales of Canadian retailers. These effects diminish with the distance to the nearest US shopping destination, relative population and the median income of the community in which the retailer operates. Using counterfactual experiments, we quantify the positive effects on Canadian retailers' sales of more restrictive border controls after September 2001, and the negative effects on those sales of increased Canadian duty free allowances and the expansion of US shopping opportunities.

Does Pak-Rupee Exchange Rate Respond to Monetary Fundamentals? A Structural Analysis

This study empirically examines the contribution of monetary fundamentals in explaining nominal exchange rate movements in the case of Pak-rupee vis-à-vis US-dollar over the period 1982Q2 to 2014Q2. The empirical results support the existence of cointegration relationship between nominal exchange rate and monetary fundamentals. The results reveal that relative money stocks and real income are the key drivers of exchange rate determination in Pakistan in the long-run. For dynamic interaction, the Structural Vector Autoregressive (SVAR) method is applied. Results from the SVAR show that the responses of exchange rate to shocks, originated from money supply, income, interest rate and inflation differentials, are consistent with the predictions of the flexible-price variant of the monetary model of exchange rate in the short-run. More specifically, the results indicate that inflation and interest rate differential explain maximum variations in exchange rate in the short-run. In essence, results suggest that monetary fundamentals are the key drivers of exchange rate fluctuations in Pakistan, especially in the short-run. JEL Classification: F31, F33, C32, F41 Keywords: Monetary Model, Exchange Rate, SVAR, Pakistan

Oil and the Naira: A Markov Switching Perspective

AbstractUsing a Markov switching regression model, the study investigated the relationship between oil price shocks and exchange rates movements in an oil‐exporting economy. On the strength of theoretical and empirical evidence, Nigerian naira exchange rates to US dollars were decomposed into two segmented time trends of depreciation (state 1) and appreciation (state 2). Empirical results provided evidence that exchange rate returns exhibited an asymmetric response to oil price shocks during depreciation and appreciation. We observed that, while the system is in depreciation, nominal oil prices had a positive influence on nominal USD/NGN, whereas nominal oil price shocks had no significant effect on nominal exchange rate movements during appreciation. In addition, real effective exchange rates appreciate with decreasing real oil prices but its depreciation does not depend significantly on real oil prices. Given that a decrease in nominal oil prices induces rapid naira depreciation and topples exchange rates stability, the study suggested that the government works towards a sustainable diversification of the economy to avoid continued over‐dependence on oil exports. Also, to rigorously pursue a sustainable fiscal policy regime in order to boost local productions, encourage non‐oil commodities exportation, and consequently increase avenues for influx of foreign exchange.

Backus–Smith puzzle and the European Union: It’s not just the nominal exchange rate

The goal of our research is testing of presence and background examination of Backus–Smith puzzle in the EU. The research is based on the technique of econometric analysis of panel data, i.e. on the estimation of one-way/two-way error component models and models without effects. The results of the research have shown that: (a) there is serious evidence on presence of the Backus–Smith puzzle in the EU, (b) its background comprises both nominal exchange rate and inflation differential, and (c) empirical data rejects complete risk sharing assumption strongly and decisively, but this does not explain the Backus–Smith puzzle. The basic conclusion of our research is that nominal exchange rate movements are not the only source of Backus–Smith puzzle in the EU, as is the case in OECD members states.

A Study on the Relationship between Exchange Rate and Consumer Prices Based on ECM

One important issue of exchange rate pass-through is the extent to which exchange rate changes affect the prices. This paper studied the pass-through effect of movements in the RMB nominal exchange rate on consumer prices. In particular, we examined whether the exchange rate pass-through to consumer prices was complete or not, and the im- pact of exchange rate system reform had on the pass-through effect. To this end, the paper used the error correction model (ECM) to conduct an empirical analysis from the first season of 1994 to the last season of 2013 period. The results showed that the pass-through of exchange rate changes to consumer prices was incomplete. In the sample period, the ex- change rate pass-through effect was on the overall downward trend. The exchange rate system reform caused structural changes in the pass-through effect. The overall pass-through effect was higher after the reform than before, and the pass- through was lagging. Finally, our results made suggestions to improve Chinese monetary policies. Price stability has become an important objective of the government's macroeconomic policy. Since 2007, China's inflation was high, showing higher inflationary pressures. After the global financial crisis, the inflation rate fell, how- ever, the major developed countries implemented quantita- tive easing monetary policy, inflation rose sharply. Signifi- cant fluctuations in the price level are the results of a variety of internal and external factors, with the increase of opening degree, the exchange rate has become an important channel for external shocks affecting the domestic economy. With the implementation of the exchange rate system reform, ex- change rate volatility increased, after sustained appreciation of the longer period of time, the RMB exchange rate in the recent period appeared sharp depreciation. Exchange rate changes may cause fluctuations in the domestic price level, i.e. the exchange rate pass-through. Exchange rate pass- through is a hot issue in the field of international economics, in which, an important issue is the extent to which exchange rate changes affect the prices (1, 2). In this paper, we investigated the pass-through effect of movements in the RMB exchange rate on consumer prices. In particular, we examined whether RMB exchange rate pass-through to consumer prices was complete or not, and the impact of the exchange rate system reform had on the pass-through effect. To the end, we applied the error correc- tion model (ECM) to conduct an empirical analysis from the first season of 1994 to the last season of 2013 period. This method can efficiently capture both the long-term and short- term dynamic changes in variables. It also maintains the long-term dynamic information of the relationship between variables, and ensures the effectiveness of the regression analysis. In the application, this paper introduced dummy variables into the model. Furthermore, it introduced mone- tary policy variable into the model, and selected foreign price index constructed to measure the cost of foreign ex- porters. This model took a lag respectively considering ex- change rate and monetary policy variables have lagged ef- fects on the price index. The results showed that the pass- through of exchange rate changes to consumer prices was incomplete. Long-term effect of exchange rate pass-through to consumer prices was -0.19. The degree of exchange rate pass-through was quite slow. In the sample period, the ex- change rate pass-through effect was on the overall downward trend. The exchange rate system reform caused structural changes in the pass-through effect. The overall pass-through effect was higher after the reform than before, and the pass- through was lagging. The remaining parts of the article are organized as fol- lows: Section 2 reviews and summarizes the existing litera- ture; Section 3 presents a theoretical model that has been constructed for studying exchange rate pass-through to con- sumer prices; Section 4 presents the empirical results; Sec- tion 5 provides the main conclusions. 2. LITERATURE REVIEW

A Small Open Economy with the Balassa-Samuelson Effect

The Balassa-Samuelson (B-S) effect implies that highly productive countries have higher inflation and appreciating real exchange rates because of larger productivity growth differentials between tradable and nontradable sectors relative to advanced economies. The B-S effect might pose a threat to converging European countries, which would like to adopt the Euro because of the limits imposed on inflation and nominal exchange rate movements by the Maastricht criteria. The main goal of this paper is to judge whether the B-S effect is a relevant issue for the Czech Republic to comply with selected Maastricht criteria before adopting the Euro. For this purpose, a two-sector DSGE model of a small open economy is built and estimated using Bayesian techniques. The simulations from the model suggest that the B-S effect is not an issue for the Czech Republic when meeting the inflation and nominal exchange rate criteria. The costs of early adoption of the Euro are not large in terms of additional inflation pressures, which materialize mainly after the adoption of the single currency. Also, nominal exchange rate appreciation, driven by the B-S effect, does not breach the limit imposed by the ERM II mechanism.

Limited Participation and International Risk Sharing: Does the Nominal Exchange Rate Matter?

In international business cycle models with complete financial markets, the consumption growth ratio moves in tandem with the real exchange rate growth. In the data, however, their correlation is often negative. International risk sharing is quite poor in reality. This consumption-real exchange rate anomaly, also called the Backus-Smith puzzle, is one of the major puzzles in international macroeconomics. Empirical results show that the nominal exchange rate movements are the main source for the Backus-Smith puzzle. This paper shows that an endogenous segmented asset markets model can solve the consumption-real exchange rate anomaly and reveal the role of the nominal exchange rate on international risk sharing. If the nominal exchange rate is fixed, international risk sharing improves in the simulated economy.

Competitiveness and growth within the CFA franc zone: Does the switch to the Euro matter?

In this paper, we seek to analyze the impacts exerted by the substitution of the French franc for the euro on real and nominal effective exchange rates, competitiveness and growth within the CFA zone. Our findings show that, since the advent of the euro, the evolution of the real exchange rates and the competitiveness (measured by currency misalignments) have become increasingly dependent on nominal exchange rate movements and therefore on the evolution of the anchor currency. While the appreciation of the euro in the last decade did not translate into strong and generalized currency overvaluations—except in Central African Republic, Benin and Equatorial Guinea—it had however strongly reduced the extent of real undervaluations induced by the 1994 devaluation of the CFA franc. This has resulted in an increasingly negative effect exerted by real and nominal appreciations on growth rates of these countries since the switch to the euro.

Optimal Exchange Intervention in an Inflation Targeting Regime: Some Cautionary Tales

Devaluations and fiscal retrenchments coming from developed countries are buffeting less developed countries. Many emerging market countries have adopted inflation targeting as “best practice,” but now they are being advised to enhance their inflation targeting regimes with foreign exchange intervention. Here we use a DSGE model to tell some cautionary tales about this advice. A Taylor rule guides interest rate setting, while foreign exchange interventions are used as a second tool of monetary policy. These interventions are effective in our model since domestic and key currency bonds are imperfect substitutes. We derive optimal (Ramsey) intervention policies in response to foreign devaluations and fiscal retrenchments, and find that they are rather complex. So, we compare the optimal responses to policies that simply smooth real or nominal exchange rate movements. Our results suggest that discretion may be the better part of valor: pure inflation targeting may come closer to the optimal policy than exchange rate smoothing. A secondary result may also be of some interest: foreign exchange interventions have a stronger impact on inflation and output in an inflation targeting regime than do sterilized interventions; the Taylor rule augments the effects of a given intervention.

Exchange Rate Determination in Developing Economies

This paper identifies the determinants of nominal exchange rate movements in less developed countries operating the flexible exchange rate system. Factors peculiar to such countries which are believed to potently drive their nominal ex-change rates are incorporated into the resulting model. In particular, the weather, parallel market exchange rate and its associated premium as well as corrupt practices enter the model. While all four factors should play crucial roles in ex-plaining short-run variations in the exchange rate, corrupt practices may still be at work in the long-run. However, those more advanced developing countries that have succeeded in instituting a relatively more effective legal system stem-ming the tide of corruption, and, also characterized by a near absence of parallel exchange rate market, may follow the standard model of exchange rate in the literature.

Real Exchange Rate Adjustment in and out of the Eurozone

It is often suggested that currency unions unduly inhibit the efficient adjustment of real exchange rates. Recently, this has been seen as a key failure of the Eurozone. This paper presents evidence that throws doubt on this conclusion. Our evidence suggests that real exchange rate movement within the Eurozone was at least as compatible with efficient adjustment as the behavior of real exchange rates for the floating rate countries outside the Eurozone. This interpretation is consistent with a model in which nominal exchange rate movements give rise to persistent deviations from the law of one price in traded goods.

Exchange Rate Determination in Developing Economies

This paper identifies the determinants of nominal exchange rate movements in less developed countries operating the flexible exchange rate system. Factors peculiar to such countries which are believed to potently drive their nominal ex-change rates are incorporated into the resulting model. In particular, the weather, parallel market exchange rate and its associated premium as well as corrupt practices enter the model. While all four factors should play crucial roles in ex-plaining short-run variations in the exchange rate, corrupt practices may still be at work in the long-run. However, those more advanced developing countries that have succeeded in instituting a relatively more effective legal system stem-ming the tide of corruption, and, also characterized by a near absence of parallel exchange rate market, may follow the standard model of exchange rate in the literature.

A Case for Interest Rate Smoothing

The aim of this paper is to determine whether it would be desirable from the perspective of macroeconomic balance for central banks to take account of nominal exchange rate movements when framing monetary policy. The theoretical framework is a small, open DSGE economy that is closed by a Taylor rule for the monetary authority, and a determinate REE that is least-squares learnable is defined as a desirable outcome in the economy. When the policy rule contains contemporaneous data on the output gap and the CPI inflation rate, the monetary authority does not have to consider the exchange rate as long as there is sufficient inertia in policy-making. In fact, due to a parity condition on the international asset market, interest-rate smoothing and a response to changes in the nominal exchange rate are perfectly intersubstitutable in monetary policy. In other words, we give a rationale for the monetary authority to focus on the change in the nominal interest rate rather than its level in policy-making. Thus, we have a case for interest-rate smoothing.

The role of expenditure switching in the global imbalance adjustment

In theory, nominal exchange rate movements can lead to “expenditure switching” when they generate changes in the relative prices of goods across countries. This paper explores whether the expenditure-switching role of exchange rates has changed in the current episode of significant global imbalances. We develop a multi-sector two-country model for the United States and the G6 countries, with the rest of the world captured by exogenous price and demand shocks, and estimate the model over two sub-samples, which cover the periods before and after the early 1990s. Our results indicate that both U.S. imports and exports have become much less responsive to exchange rate movements in recent years, mainly due to changes in firms' pricing behavior and global trade pattern. These findings suggest that the exchange rate would have to move by a much larger amount now than in the 1970s and 1980s to reduce the U.S. trade deficit by a given amount.

The Real Exchange Rate Fluctuations Puzzle: Evidence For Advanced And Transition Economies

This paper tries to analyze the sources of the real exchange rate fluctuations for a set of advanced economies and Central and Eastern European transition economies. To address this, in a first step, we compute two measures of the share of the variance of the real exchange rate accounted for movements in the relative prices of traded goods between the countries. One measure is based on R2 coefficient and the other one is based on the mean-squared error (MSE) of the changes in the real exchange rate. In a second step, we estimate structural (identified) vector autoregression (SVAR) models, and decompose real and nominal exchange rate movements into those caused by real and nominal shocks. In a third step, we complete previous ones with an impulse-response analysis. Three central messages are derived from results: (1) for transition economies, under regimes of managed nominal exchange rates, the relative price of non-traded goods explain a large percentage of the variance of the real exchange rate; (2) there is evidence of instability in the variance decomposition of the real exchange rates for advanced economies across samples, and (3) as result of diverse fiscal and monetary policies in transition economies, real exchange rates in some economies are driven mostly by real shocks while in others are driven mostly by nominal shocks.

Structural Decomposition of Exchange Rate Shocks in Pakistan: An Empirical Investigation using SVAR Methodology

This study is an attempt to decompose nominal and real exchange rate movements in Pakistan into components induced by real and nominal shocks. Using the Blanchard and Quah (1989), famously known as B-Q, methodology for the period 2000:1–2009:12, the study finds that real shocks affect both nominal and real exchange rate. Similarly, the nominal shocks have a permanent effect on nominal exchange rate but have temporary effect on real exchange rate. Moreover, speed of convergence is different between the two rates affected by the same shock. These results put forward that nominal devaluation is not followed by real devaluation and resultantly will not improve trade balance situation. The policy makers, therefore, need to be careful while taking any decision regarding nominal devaluation as it may also lead to worsening of, instead of improvement in, trade balance.