MSc in Finance and International Business
Author: Bahodirjon Boykorayev
Academic advisor: Associate Professor Erik Strøjer Madsen
Factors that determine nominal exchange rates and
empirical evidence of cross-sectional analysis
Aarhus School of Business
August 2008
Abstract
While there has been voluminous research on the determinants of exchange rates for
developed and developing countries, majority of works, considering selected issues
theory of exchange rates, is quite fragmented. This paper combines many factors
forming the exchange rate and the factors of choice of exchange rate regime in small
open economies. The present research work examines determinants of Nominal and
Real exchange rates for the period 1974-2003. This thesis addresses the basic theory
of the exchange rate, which emphasizes the influence of various factors on its
dynamics, as well as - the possibility of building a universal theory that would be
correct for most countries and with different economic conditions. It was found that
model is not applicable in the same conditions, as the significance of factors is
changing as targeted country groups changed. Empirical evidence show that
significance of factors in the model has changed in comparison to prior research
papers.
Keywords: Nominal exchange rate, Real exchange rate, Inflation, Floating exchange
rates, Fixed exchange rate, Optimal exchange rate regime.
1
Table of Contents
INTRODUCTION .............................................................................................................. 3
1. THEORY OF THE EXCHANGE RATE.............................................................................. 6
1.1. Essence of the exchange rate, types and functions.............................................. 6
1.2. The theory of purchasing power parity. .............................................................. 8
1.3. Factors affecting the value of the exchange rate ................................................. 9
1.4 Best national monetary system and optimal exchange rates .............................. 10
1.5 Fixed Exchange Rates ........................................................................................ 12
1.6 Free-Floating Exchange Rate ............................................................................. 15
1.7 Advantages and disadvantages of alternative exchange rate regimes ................ 19
2. LITERATURE REVIEW ................................................................................................ 22
3. EMPIRICAL ANALYSIS ............................................................................................... 31
3.1 Data Description and Methodology ................................................................... 31
3.2 Empirical Analysis ............................................................................................... 33
3.3 Interpretation Of Results.................................................................................... 39
CONCLUSION ................................................................................................................ 42
APPENDIX ..................................................................................................................... 44
BIBLIOGRAPHY ............................................................................................................. 63
2
INTRODUCTION
In recent decades, it is observed a rapid development of global capital market and
financial services. In these circumstances, the dynamics of exchange rates have an
increasing impact on the overall macroeconomic situation in countries around the
world. This applies particularly to small open economies, where domestic monetary
policies don’t have an impact on world interest rates. For these countries, the
exchange rate becomes a major tool to adapt to changing external conditions.
Currency crises in Latin America, South-East Asia and other selected countries have
shown that the imbalance of monetary policy can lead to serious consequences for the
entire financial system of countries, and in a high degree of capital mobility - and to
systemic crises worldwide. Therefore, identification and analysis of the factors
determinants exchange rates the theoretical task, which has a great practical
significance.
The theories of the exchange rate began to grow in the beginning of 1960s. Few years
later, the works related to the theoretical methods applied in monetary policy
appeared. It should be noted considerable diversity theories of exchange rates, which
have been developed to date. However, the analysis shows that the majority of works,
considering selected issues theory of exchange rates, is quite fragmented. There are
few works carried out, conducting a comprehensive analysis of the factors forming the
exchange rate and the factors of choice of exchange rate regime in small open
economies.
This thesis will address the basic theory of the exchange rate, which emphasizes the
influence of various factors on its dynamics, as well as - the possibility of building a
universal theory that would be correct for most countries and with different economic
conditions.
In 1971, it ceased to operate the Bretton Woods system of fixed exchange rate. And
since 1978, operates so-called Jamaica monetary system. The basic principles of this
system are that, the countries have their own choice to any system of the exchange
3
rate - fixed or floating, established unilaterally or through multilateral agreements. As
a result, the dynamics of the exchange rate has become to provide greater influence on
the overall macroeconomic situation than it was before.
The successful outcomes of policies and practices of floating exchange rate is that the
mechanism of this type is most suited to modern principles of openness of national
economies and their integration with the world economy. In turn, the system of fixed
parities forcing the country to hold the exchange rate at a certain level, which may
hinder the direct effect of external factors on the domestic economy. It conserves the
structure and proportions, which are no longer relevant for changed international
conditions of production and exchange.
The purpose of the thesis is to determine the factors affecting the dynamics of the
exchange rate and the choice of exchange rate regime.
To achieve the desired objective study identified the following tasks:
-
Analyzing the content and the evolution of theoretical approaches to
determining the factors forming the exchange rates;
-
Develop a methodology for determining the factors forming the exchange
rates;
-
Determine the composition of the factors affecting the dynamics of the
exchange rate and the choice of exchange rate regime; direction of these
factors;
-
Identify and justify the difference in determining the factors forming the
exchange rate between developed, developing countries and countries with
economies in transition;
-
Examine methods of monetary policy in different countries in terms of
matching official and the real objectives of monetary policy.
Theoretical and methodological foundation served as a design study of scientists in
the field theories exchange rate, methodological recommendations of international
financial organizations. In his study I relied on primary sources - monographs and
4
articles of recognized experts in the field of economic theory of exchange rates and
inflation.
For statistical model I use nominal exchange rate as an equation of inflation
differential and real exchange rate. For the empirical part Regression analysis is
chosen. To maintain the power of the model and preciseness of the determinants OLS
method is applied. Theoretical fundaments will base on Purchasing Power Parity
(PPP) for national currencies and Barro-Gordon policy for long run inflation rates.
The research paper starts with introduction and follows by theoretical base. Literature
review is submitted in the next chapter. The following chapter covers Model, Data
description and methodology. Empirical analysis of cross-sectional data is viewed at
the end of the third chapter. Conclusion of the research is given afterwards. Then
follow references and appendices.
5
1. THEORY OF THE EXCHANGE RATE
1.1. Essence of the exchange rate, types and functions
Each country has a currency in which the prices of goods and services are quoted—
the dollar in the USA, the euro in France, the pound sterling in the UK, the yen in
Japan, and the kroner in Denmark and hundreds in a line. Exchange rates play a
central role in international trade because they allow us to compare the prices of
goods and services produced in different countries. In daily newspapers you can see
relative prices of national currency per foreign unit. Weekly or monthly magazines
and journals show growth trends over specific period. As long as exchange rates are
part of our everyday business or main factor that effect the way how our business
goes, it is worth to analyze how currency rates change and what are the determinants
that control this movement.
One of the major elements of monetary system of a country is the exchange rate,
where the exchange value of national currency of one country expressed in monetary
units of another country. The studies on exchange rates and possible variations of
currency rates attracted great interest in 70s; and so far this topic one of the leading
ones in economic sphere. The scholars have presented several types of exchange rates.
But I will follow most common types which are practiced in IMF staff papers.
This classification system is based on scholars’ researches, names may be different in
official arrangements. The order of exchange rate arrangements is on the basis of their
degree of flexibility and the existence of commitments to exchange rate paths (IMF
International Financial Statistics).
1. Exchange arrangements with no separate legal tender
2. Currency board arrangements
3. Conventional fixed peg arrangements
4. Pegged exchange rates within horizontal bands
5. Crawling pegs
6. Exchange rates within crawling bands
7. Managed floating with no predetermined path for the exchange rate
8. Independently floating
6
For full description and country classification by exchange rata regimes see appendix.
For the ease of usage I rename most used ones as free floating, managed floating and
fixed exchange rate regimes.
In free floating system the exchange rate is formed under the influence of the market
demand and supply and may vary significantly in size. The size of the demand for
foreign exchange is determined by the needs of the country in imports of goods and
services, tourist spending in the country, demand for foreign financial assets and
demand for foreign currency in connection with the intentions of residents to invest
abroad (Deverux and Engel 1998).
In managed floating system, besides supply and demand, the central banks of the
country have a strong impact on value of exchange rate, as well as various temporary
market distortions.
A fixed exchange rate or pegged exchange rate is a type of exchange rate regime
where a currency's value is matched to the value of another single currency or to a
basket of other currencies like SDR, or to another measure of value, such as gold. As
the reference value rises and falls, so does the currency pegged to it (Krugman &
Obstfeld, International Economics). In addition, countries with fixed exchange rates
lose control over independent domestic monetary policy to achieve internal stability.
Fixed exchange rate fluctuates within the narrow framework. An example of the fixed
rates system is the Bretton-Woods currency system (1944-1971). Gold-dollar standard
established at Bretton Woods in reality functioned on a dollar basis, since only the
U.S. tried to maintain direct convertibility of their currencies into gold. The basic idea
of Bretton Woods agreement was to guarantee freedom of payments, particularly in
barter.
One of the most important concepts used in the foreign exchange market, is the notion
of real and nominal exchange rate. The real exchange rate can be defined as the ratio
of prices of goods the two countries made in the respective currency. The nominal
exchange rate shows the rate of exchange rates, operating in the present moment in
the foreign exchange market (Krugman & Obstfeld, International Economics).
7
The rate of the national currency may vary differently towards different currencies
over time. Thus, in relation to strong currencies, it can fall, but against the weakest rise. That is why exchange rate index is calculated to determine the full dynamics of
the currency.
Exchange rates help to stabilize external relations of the economy and maintain fair
trade. However, any type of currency regimes has similar purposes (Bilson & Marton
1984). The main functions of exchange rates:
• Mutual exchange of currencies for trade in goods, services, within loans and capital
movements. Exporter exchanges earned foreign currency on the national, as the
currency of other countries cannot be circulated as a legal means of circulation for
purchasing and payments on the territory of the country. Importer exchanges foreign
currency to pay for goods purchased abroad. The debtor buys foreign currency for
national currency write off debt payments and interest payments on foreign loans;
• Comparison of prices of world and national markets, as well as the to assess
economic indicators in different countries, expressed in national or foreign currencies;
• Periodic reassessment of euro-currency accounts in companies and banks.
1.2. The theory of purchasing power parity.
According to Purchasing Power Parity theory, in the long run, identical products and
services in different countries should cost the same in different countries. This is
based on the principle that exchange rates will adjust to eliminate the arbitrage
opportunity of buying goods or services in one country and selling it in another. For
example, take a cell phone that costs 2000 DKK in Denmark and an exchange rate of
5 Kroner to 1 USD. If the same phone costs 500 dollars in the USA, American
consumers would buy the cell phone in Denmark. If done on a large scale, the inflow
of U.S. dollars would drive up the price of the DKK, until it equalized at 4 Danish
Kroner to 1 USD - the same ratio of the price of the cell phone in Denmark to the
price of the phone in the U.S. The theory only holds for tradable goods, not to
immobile goods or local services. The theory also ignores several real world factors,
8
such as transportation costs, tariffs and transaction costs. The other assumption is
existence of competitive markets for the goods and services in both countries.
The purchasing power parity (PPP) exchange rate is the exchange rate between two
currencies that would equate the two relevant national price levels if quoted in one
currency at that rate, so that the purchasing power of a unit of one currency would be
the same in both countries. This concept of PPP is often termed absolute PPP.
Relative PPP holds when the rate of depreciation of one currency relative to another
equals the difference in aggregate price inflation between the two countries
concerned. If the nominal exchange rate is defined simply as the price of one currency
in terms of another, then the real exchange rate is the nominal exchange rate adjusted
for relative national price level differences. When PPP holds, the real exchange rate is
a constant, so that movements in the real exchange rate represent deviations from PPP
(Sarno and Taylor, 2002).
Purchasing power parity (PPP) is the cost base of exchange rate. Purchasing power
evaluates the national average price levels for goods, services and investments. Under
the free exchange of banknotes into gold, silver or other valuable metals and assuming
the freedom of gold trade between the countries, the exchange rate slightly deviates
from the PPP due to operation of gold mining and availability of underground wells.
1.3. Factors affecting the value of the exchange rate
Like any price, exchange rate deviates from the valuation basis - the purchasing
power of currencies - under the influence of demand and supply of currency. The
correlation of such supply and demand depends on several factors. Multiple factor
exchange rate reflects its relationship with other economic categories - cost, price,
money, interest, the balance of payments, etc.
In this paper I have selected several factors that I found significant in changes of
exchange rates. They are GDP growth, inflation, country size, openness ratio, terms of
trade, Central bank independence and government debt variables. Detailed
information for each of variables is presented in data description and empirical part.
9
1.4 Best national monetary system and optimal exchange rates
Areas of government exchange controls (NB, the Ministry of Finance, etc.) are
determined on the basis of the criteria for best national monetary system. To
select the optimal exchange rate regime and an effective system of currency
regulation should be:
—defined the criteria optimal elements of national monetary system,
—considered the features of different types of currency regimes for use in the
country
—clarified existing principles of currency regulation policy-making mechanism
The currency regime – is a set of forms and methods used in setting the exchange rate.
The main objective of any exchange rate regime, is to protect the external
competitiveness of the economy by strengthening balance of payments and stabilizing
production (Deverux & Engel 1998).
In the economies in transition countries the exchange rate does an important function.
It is used to remove distortions in the structure of relative prices of goods and
services, remained from the previous state of the economic system in which pricing
was not in the light of market mechanisms. In market-oriented economy,
manufacturers of exported goods adjust their production under world prices, after
which happens adjustment of relative prices of non exporting goods. In the result, the
national economy is integrating into the global structure of relative prices.
In selecting the exchange rate system (currency regime) government usually guided
by the following criteria:
-- The current level of competitiveness of the economy;
-- The balance of payments and financial system;
-- State foreign exchange reserves;
-- Economic and political climate in the country, etc.
10
When choosing a system of exchange rate, the Central Bank actually makes the
choice between regulation of trust units, which can be identified - domestic credit,
balance of payments deficit, international reserves and external debt.
The main criterion of the optimal exchange rate regime and exchange control
mechanism can be defined as minimizing the deviation of real production volumes of
the national economy in case of crisis, arising from the external and internal factors of
production volumes in times of economic recovery (Richard Cooper 1999).
Historically, cash flows are classified as current accounts and capital flows in Balance
of Payments. The results of this direction of currency regulation aimed to finding
additional sources of financing of foreign trade imbalances and create conditions for
their elimination:
-- The implementation of direction of currency regulation is defined by IMF experts,
as the use of legislative intervention mechanisms;
-- The implementation of economical mechanism is defined as the implementation of
operations in the "open market".
There are two main foundations of monetary exchange rate regimes in the world
practice. Stabilization of the economy can be carried out through one of these
regimes:
1) A mechanism of fixing or pegging the national currency exchange rate against
another currency or basket of currencies;
2) Regime, opposite to the first, based on freely floated currency exchange rates.
Implementation of the explicitly defined instrument for currency regulation, one of
the two currency regimes in a particular country does not happen, because it does not
give the positive effect for the national characteristics of the given economic
instrument. However, flexible currency regimes, such as "managed" or "pegged to
11
several currencies", are gaining an increasing popularity in many countries (Obstfeld
& Rogoff 1995).
The evolution of currency regimes in the world practice shows a trend of gradual
transition from fixed exchange rate regimes to the more flexible exchange rate regime.
The core mechanism of currencies with flexible exchange regimes is a real demand
and supply of the national currency in the domestic and foreign markets.
1.5 Fixed Exchange Rates
In fixed exchange rate system central bank sets the exchange rate at a certain level in
relation to the currency of any country which its currency or the ―currency basket‖ is
"tied" with. The peculiarity of the fixed rate is that, it remains unchanged for long
time (several years or several months), i.e. it does not depend on changes in supply
and demand in the currency. Changing a fixed rate occurs as a result of its formal
revision (devaluation or revaluation) by central bank (Edwards & Losada 1994).
With a fixed rate the central bank often sets the various rates on individual
transactions.
Fixed exchange rate’s system has the following advantages:
-
Quantitatively predictable (promotes trade and stimulates the flow of capital);
-
increases high confidence in the monetary policy, decreases government
expenses spent to control inflation;
-
stabilized inflation, reduces inflationary expectations in the labour market and
financial markets.
However, this system is not without shortcomings. Country is not able to resist
certain economic shocks resulting from loss of export markets and insufficiency of
foreign exchange reserves to support the fixed rate. Typically, these phenomena are
12
accompanied by a sharp decline in domestic prices, which predefine recession and
rising unemployment (Frenkel 1999).
When setting a fixed rate system there is a problem of clarifying the correct price of
currencies, but in case of pegging to one currency, the country is characterized by the
following:
-
This policy is easily manageable by all companies in financial markets within
the country;
-
The possibility of government manipulation of exchange rates is significantly
reduced;
-
The risk of exchange rate in trade is reduced if partners trade in one currency,
and favorable for the major trading partners;
-
The fluctuation of exchange rate of any currency foretells the change of the
exchange rate against all other foreign currencies. Other advantage of the
following system is that exchange rate fluctuations are much less, if the
currencies in the basket are equally weighted.
Fixed rates are committing financial regulatory organizations for a more strict
monetary policy and price discipline, which helps rapidly to reduce inflation to lower
losses for the economy. Fixation of exchange rate in the medium term can help to
limit inflation costs in the economy under the influence of imports.
With fixed exchange rates and mobile capital, the Central Bank cannot simultaneously
regulate the supply of money and exchange rate, as market agents have the
opportunity to convert the national currency into foreign assets. The monetary
expansion lowers interest rates, and capital move abroad. With the substantial
increase in money supply, fixed exchange rate, as the depletion of foreign reserves,
will be under high pressure. The central bank will be forced to take action to tighten
monetary regulation and to raise short-term interest rates on deposits to retain a fixed
exchange rate level (Frenkel 1999).
13
Keeping the fixed exchange rate becomes quite problematic. The Central Bank may
try to eliminate the impact of changes in foreign exchange reserves on money supply
through a devaluation of the exchange rate. If such adjustments are not made, the
exchange rate can potentially suffer even greater pressure.
As international experience has shown, fixed exchange rate operates best in the
country with the following conditions in the economy:
-
A small and open economy under the influence of a strong currency (or
currencies of major trading partners);
-
A significant portion of foreign trade is carried out with a country whose
currency is pegged to the national currency (for a stable trade environment for
domestic producers);
-
Macroeconomic policies oriented at keeping the inflation at the level of the
country, which currency attached to (in case of low rate of inflation);
-
Structural reforms are being implemented in the country, and there is a real
independence of the Central Bank.
However, fixed exchange rate without a tangible reforms cannot ensure long-term
macroeconomic stabilization. Therefore, with implementation of a fixed rate, the
Government needs to balance the macroeconomic indicators such as the money
supply, the volume of goods and services and prices. It is very important to prevent
the growth of nominal wages; otherwise it will ―eat‖ the profit growth of enterprisesexporters, who are unable to raise their prices accordingly because of the need to
remain competitive in the global market (Bubula & Ötker-Robe 2002).
Thus, when using the fixed exchange rate, the country requires substantial foreign
reserves to gain and then maintain confidence in the national currency, as well as
ensuring full convertibility of national currency into foreign currency.
Fixed exchange rate is effective:
1. when central regulatory bodies have substantial reserves of foreign currency;
2. if there is no sudden price shocks;
3. in the case of pegging to a basket of currencies.
14
In economy of transition countries, the use of the nominal exchange rate is limited to
the fact that inflation in these countries is not only monetary origin, but also linked to
the deformation of the pricing mechanism, a strong monopoly in the economy and
default in payments.
Fixed exchange rate is usually not effective on crisis of balance of payments because
of the inevitability of macroeconomic adjustments. When exchange rate is fixed, the
effectiveness of fiscal policy relatively higher than monetary. Because the entire
effect of changes in the money supply is spent for maintaining the exchange rate and
does not affect the levels of employment and production.
1.6 Free-Floating Exchange Rate
The regime of free floating exchange rate takes into account the ratio of supply and
demand in the national currency. In the absence of sufficient reserves for
interventions, in order to maintain the announced target exchange rate level, the most
acceptable option for the Central Bank turns to be free-floating exchange rate regime.
However, the implementation of such a decision deters from the need of frequent
changes in the exchange rate. Public authorities of monetary regulation are disabled to
allocate the foreign currency with legislative process (Deverux & Engel 1998). In
free-floating exchange rate regime occurs frequently changing of exchange rate under
the influence of real demand and supply for foreign currency on the domestic and
foreign currency markets.
The central bank usually follows the exchange rate and determines its impact on
domestic price changes. In economy of transition countries, there arises a situation
where domestic prices are targeted to the exchange rate. In industrialized countries,
the exchange rate depends on the price level. The Central Bank can influence the
dynamics of the exchange rate by changing the interest rate. Successful
implementation of free-floating exchange-rate regime requires less foreign reserves
than in fixed exchange rate regime. Flexible exchange rates more favorable for
countries with a stable and planned monetary and fiscal policies.
15
Eliminating the instability of economic policy as a source of internal instability,
means that the greatest influence will provide foreign trade sector, flexible exchange
rates help to overcome their negative effect with the least losses for the economy.
If the economy of the country is widely diversified, the price elasticity of demand will
be quite high, and floating exchange rate system will be able to function smoothly and
more effectively respond to the needs of domestic regulation, as well as external
(Backetti, Hakkio & Jones 1995). The more open economic system, the stronger the
effect of exchange-rate on stability in the relative prices in local currency and resource
allocation.
Mechanism of floating exchange rates is divided into "clean floating‖ and ―dirty
floating‖. Clean floating - central bank does not intervene in the foreign exchange
market. Dirty floating - there is periodically intervention in the foreign exchange
market.
This exchange rate allows you to maintain competitiveness and quickly adapts to
external shocks and impulses, and the most important - the Government is relieved of
the functions of determining an appropriate exchange rate. Despite these advantages,
the regime of free floating exchange rate is not without flaws:
-
if the foreign exchange market is characterized by low capacity, then some
few large transactions can undermine existing state;
-
this regime can ensure the effectiveness of monetary policy in regulation by
the state, as well as taking financial and fiscal measures;
-
it can be unattractive to foreign investors and trading partners because of
uncertainty in this regime;
-
There is a threat to government manipulation (―dirty floating‖), thus
undermining the credibility of market agents
-
if there is large speculative capital flows in the country, the determination of
exchange rates greatly limits the monetary and financial independence.
16
Employment of the regime is most effective in the case of weak development of
international commercial relations, i.e. when the volume of production is not heavily
dependent on foreign trade (Frenkel 1999).
Main conditions for implementation the floating exchange rates are existence of
developed financial market, integration with the international system, the
interchangeability of domestic and foreign monetary assets. Nevertheless, despite the
absence of these factors, many countries have shifted to a floating rate regime. The
reasons for this are imbalances in balance of payments, minor amounts of official
foreign exchange reserves to support the fixed rate and desire to block the "black"
exchange markets. First, industrially developed countries shifted to this system and
then developing countries followed. But implementation the floating-rate of national
currencies occurred within the limits of stabilization programs of IMF and availability
of technical assistance; this caused a need for a set of economic measures such as
economic restructuring, the liberalization of monitory and customs regimes, limiting
demand, etc. In case of lack of these prerequisites, many countries are using a
combination of fixed and floating rates. The main idea of this kind of crawling pegs
is to conduct small-scale and partial currency exchange adjustments that are repeated
once or twice a month (Dunn & Mutti, International Economics).
The following attributes of crawling are pros to mention:
-
preliminary announcement rate of crawling, which increases the confidence of
exporters and potential investors;
-
the possibility of maintaining actual fixed exchange rate. For example, when
domestic inflation is 10% per year and inflation of the trading partner is 5%
annual, the rate of creeping is set in the 5% depreciation per year.
Cons of crawling peg rate are followings:
-
optimal exchange rate can vary over time, causing a constant need to adjust
the rate of crawling in order to avoid destabilization of the economy;
-
regime could lead to higher inflation than in the fixed exchange rate.
17
Currency regime, based on a floating exchange rate is most effective:
-
In countries with stable economies with multilateral foreign trade relations and
predictable fiscal and monetary policies;
-
In case of hyperinflation;
-
In a system of managed floating;
-
For regulation the balance of payments crisis.
Choosing the free-floating rate eliminates the problem of determining the level of the
national currency exchange rate, because the problem of determining the value of the
currency is solved at the market. The benefit of such a regime is also the fact that, in
such a situation there is no problem in imbalance of balance of payments resulting
from depletion of official reserves in foreign currency, which is occurred during the
regime of fixed exchange rates (Frenkel 1999).
It should be noted that, the slowdown in rate of inflation and stabilization of the
economy through regulation of money supply and use of free floating exchange rate
requires from the Central Bank of the country to implement certain interventions to
prevent excessive currency fluctuations. Experience of developing countries has
shown that, the most progressive reforms in the former socialist countries, managed
floating is possible only if the Central Bank manages to build enough foreign
exchange reserves or through the achievement of current account surplus, or through
loans from international organizations.
Like any other regime, regime of independently floating rate should be reviewed
taking into account the national circumstances of economy of the country, in which it
is intended to use. Otherwise the national currency can lead to negative consequences.
Full freedom of movement of capital, in case of economic reformation, may result the
increase of speculation in the national currency, which are particularly devastating in
the initial phase of the reformation process. The large capital flows can cause big
fluctuations in the level of official foreign exchange reserves and thereby influence
the money supply. These fluctuations, in turn, make the interest rate on deposits very
unstable and further create an atmosphere of distrust.
18
In these circumstances, when country's economy is experiencing structural changes,
the currency restrictions may contribute to the stability and independence of monetary
policy. The Central Bank must develop the clear principles of organization of
exchange controls, as part of exchange controls, to minimize the destabilization of
speculative expectations.
1.7 Advantages and disadvantages of alternative exchange rate regimes
The choice of exchange rate regime is determined to a large extent by the economic
objectives of the Government:
-
Regime of fixed exchange rates constrains the government with a
negative balance in international payments. Consequently, when
moving to a floating exchange rate regime, the countries with deficit in
balance of payments have more freedom;
-
For countries with deficit in balance of payments deflationary policies
are recommended, for countries with surplus – inflationary policy. In
this case, the rejection of fixed-rate and shifting to a floating regime
leads to inflationary policies.
In case of downturns within the economy, it is necessary to consider and take into
account the reasons for its occurrence – it could be either in the financial area, or in
production.
In case of crisis caused by disorder in financial markets, as a result of short-term
market fluctuations, the fixed exchange rate regime will allow to stabilize crises for
short term, on condition that Central bank has strong international reserves. In case of
crisis in the sphere of production, the use of fixed-rate regime without a radical
restructuring economic mechanism will lead to the depletion of foreign reserves of the
State and worsen external economic imbalances in the form of deficit in balance of
payments (Deverux & Engel 1998).
19
It can be concluded that the choice of best option exchange rate regime should be
implemented by taking into account the national characteristics of the economy:
-
A system of fixed exchange rates is more effective in stabilizing the
money and the money market, while flexible exchange rates has more
advantages to stabilizing production and improve the balance of
payments;
-
if the country in the single monetary zone of fixed currency exchange
rates, fixed rates are applied in short-term market fluctuations in the
domestic financial market. Prolonged use of fixed exchange rate regime
can lead to unnecessary expenditures of maintaining fixed rate and
macroeconomic imbalances.
In addition, when choosing a regime of exchange rates it is important to take into
account the rate of inflation and the level of the reserves in foreign assets:
-
If the country's inflation rate slightly higher than the rate of inflation
abroad, depreciation of own currency should be implemented. But if there
is significant difference in the level of inflation, and the imbalance in the
structure of costs and prices is remarkably high, then in order to get out of
current crisis, floating exchange rates will be implemented on both a short
and long term;
-
If the foreign exchange reserves severely depleted, and the external debt
has reached a very significant level, it is necessary to have stronger
regulation of the exchange rate in order not only to maintain international
competitiveness, but also to build a reserve, which is necessary for
adjustments of volatility of balance of payments.
None of the optimal currency regimes can fully protect the national economy from
external shocks (Frenkel 1999). The exchange rate regime is the only supplementary
instrument of national monetary system. Only an effective mechanism of currency
20
controls, built on clearly defined principles, minimizes and warns about the
consequences of external shocks to financial markets.
Policy measures of currency regulation in a certain period of time have a positive
impact on economic developments within the country, investing domestic savings for
manufacturing inside the country. However, the legislative regulation in general
cannot substitute the economic policy which is oriented to stabilize prices. Currency
restrictions cannot provide long-term stability of the exchange rate and exchange rate
policies. Such a long term stability is possible only on condition that the mechanism
of monetary policy is directed to stabilize prices and to set strong foreign trade
balance.
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2. LITERATURE REVIEW
In the analysis of literature I focused firstly on works about exchange rates in general
and then by each factor selectively. The main concern was, considerably, the founders
of approaches or models where I could get basic insights of the reviews.
The topic of currency exchange rates and factors those drive exchange rates change
have been reviewed by many scholars in the last decades and still remains to be one of
the hot topics in international economic studies. In the works about exchange rates the
analyses were theoretically proven and found empirical evidence as well. Most of the
scholars came to similar conclusion, even though they focus not the same factors.
In the center of my research is notion of exchange rate, which has long term effect on
the economy. And from nominal exchange rates position, inflation is the main factor
for rate changes. Defining currency exchange rates by inflation takes grounds BarroGordon model of explaining monetary policy (Barro&Gordon, 1983).
The first attempts to analyze exchange rates behavior was done by Rudiger
Dornbusch(1973), Richard Meese(1979) and Kenneth Rogoff(1983).
Since his first major publication in 1973, Rudiger Dornbusch has been one of the most
productive and influential economists working on exchange rate economics. Three
papers written since 1980 on special exchange rate arrangements, black markets, and
stabilization policies under inflation are directed to the experiences of some of the
Latin American countries. He also includes papers treating overlapping wage
contracts, incomes policies as supplements to devaluation, imperfect substitutability
of internationally traded financial assets, and imperfect competition and oligopoly as a
means of understanding how prices respond to changes in exchange rates. The essay
on purchasing power parity (1987), effectively summarizes its history, problems, and
potential. Dornbusch makes clear that it remains an important concept, though the
evidence in recent years is more remarkable for deviations from, than observance of,
such parity. I his work in 1986 he used modified Mundell-Fleming model to include
exchange rate expectations and lagged price adjustment. The shortcoming of that
model was that only short run and short-to-medium run portfolio model could be
22
analysed. Dornbusch mentioned the failure to include real assets and investment as
one of the limitations of the modified Mundell- Fleming model, along with an absence
of effects from the current account and the assumption of perfect substitutability
between home and foreign bonds. He also emphasized the rewards that may come
from bringing tools of industrial organization into exchange rate analysis. Moreover,
he suggests taxing international transactions to reduce speculative capital flows and
the excessive volatility of exchange rates that they produce.
In 1980s Richard Meese and Kenneth Rogoff first explained the shortcomings in
monetary models of exchange rates, they were first to say ―exchange rates essentially
follow a random walk, and whatever "fundamental" determinants may be present have
eluded empirical research‖. But before in 1979 Michael Mussa set a standard that
seemed both reasonable and achievable: a reduced-form exchange rate model proved
itself by explaining 10 % of the quarterly variation in rates between the major floating
currencies. In the Journal of International Economics, Meese and Rogoff (1983)
focused on out-of-sample forecast failures, and Boughton (1987) showed that
monetary models performed just as badly as inside sample. Subsequent literature
examined whether the problem was that the basic model should be expanded to
incorporate more structural features, simplified and directed toward lower frequency
variation, or scrapped altogether. Jerome Stein and Polly Reynolds Allen developed
new ―Natural Real Exchange Rate‖ (NATREX) approach, they stressed that the
natural rate was a moving equilibrium that depended on internal changes in stocks of
external assets and liabilities (Stein et al. 1995). The valuable property of the
NATREX was that in a short term analysis it was possible to integrate stocks and
flows.
The combination of exchange rate analysis and the factors that determine nominal
exchange rates was clearly performed by Philip Lane (Lane 1999), he did theoretical
and empirical research on long-run exchange rates and built own model. He analysed
long run nominal and real exchange rates, and added to his model variables like trade
openness, country size, central bank independence (CBI) and government debt. One
of the special points of his work was that he analyzed 107 countries for the period of
1974-1992. Before him all the works had included only special concentrated regions
of developed countries within less time period.
23
As he constructed model, nominal and real exchange rates had different determinants
for empirical data, and he carried out LS regression to get the statistical results. As a
benchmark country he used the USA, indeed US dollar assumed to be best
comparison for currency exchange rates after Bretton-Woods system (Lane 1999). For
real exchange rates economic growth and terms of trade were chosen as potentially
important factors. To obtain estimates for nominal exchange rates he used openness,
size, debt, CBI index and inflation, but as long as some of the variables are as
important to analyze real values as nominal ones, Lane constructed equations with
selected determinants.
As of empirical analysis, Lane created several classifications: countries with inflation
higher than 30% and vice versa; countries with non-autonomous exchange rates,
countries with high appreciation/depreciation rates, etc. His econometric results show
that the factors driving long-run inflation are as important as for exchange rates.
Explanation power of the model declined while the excluding countries with high
inflation and high depreciation rates (Lane 1999). In full sample data, openness,
output growth and the terms of trade resulted to be significant, but country size was
insignificant. In overall, results show that the debt effect is most important for high
depreciation/inflation countries. Openness, size, and the stock of nominal government
debt - variables that affect the tendency to inflate - are significant in explaining the
rate of nominal depreciation. However, the support on central bank independence is
weaker. The output growth rate - which affects the long run in the real exchange rate also is important in explaining the nominal exchange rate. However, the results for the
terms of trade, another factor that ought to affect the nominal exchange rate via its
influence on the real exchange rate, are mixed. For the OECD, and consistent with the
PPP evidence, the factors driving inflation appear to dominate the determination of
the nominal exchange rate (Lane 1999).
In extending of his work, Philip Lane stated that considerable progress needed to be
made in achieving a better understanding of the determination of the real exchange
rate and a large fraction of the long-run variation in real exchange rates across
countries remained to be explained. In later parts of my thesis, I would add updated
data for Lane’s model of exchange rate formulation and identify changes over time
interval.
24
One of the prominent researches in the field of exchange rate fundamentals is done by
Peter Clark & Ronald Macdonald in 1998. They compare two approaches for
exchange rate determinants: Fundamental Equilibrium Exchange Rate (FEER) and
Behavioral Equilibrium Exchange Rate (BEER) (Clark & MacDonald 1998).
In FEER approach the equilibrium exchange rate is defined as the real effective
exchange rate that is consistent with macroeconomic balance, which is generally
interpreted as when the economy is operating at full employment and low inflation
(internal balance) and a current account that is sustainable, that reflects underlying
and desired net capital flows (external balance). This exchange rate concept is denoted
as ―fundamental‖ in that it abstracts from short-term factors and emphasizes instead
determinants that are important over the medium term. An assessment of a country's
exchange rate was made by comparing its current level with the calculated FEER
(Clark & MacDonald 1998).
BEER approach is the use of an estimated reduced-form equation that explains the
behavior of the real effective exchange rate over the sample period. This paper
illustrates two approaches with the estimation of equations for the real effective
exchange rates for the German mark, the Japanese yen, and the U.S. dollar using
cointegration methods. The sample period is 1960-1990 and the USA, Germany and
Japan had been chosen. As for BEER variables Real effective exchange rate, Terms of
trade, price ratio of non-traded goods to traded goods, Net foreign assets, stock of
government debt and real interest rate constructed the equation. As we can see Clark
& MacDonald (1998) and Philip Lane (1999) introduced similar models except for
exact number and name of determinants.
But unlike Lane, Clark & MacDonald performed statistical country by country
separately so that there would be no correlation among country specific data.
They have done comparison of BEERs and FEERs to see the extents of the two
models. It showed that the dollar would have been considerably stronger, using the
BEER analysis, if the U.S net foreign asset position had not deteriorated since 1980
(Clark & MacDonald 1998). But the comparison of the estimated BEER with the
FEER for the German Mark was not very revealing. By contrast, the BEER estimates
for the yen appear to be plausible, particularly over the second half of the sample. As
25
the BEER analysis showed a strong upward trend in the estimated equilibrium value
of the yen, the estimated FEER overvalued the average real values (Clark &
MacDonald 1998).
It is notably that FEER comparisons are made on past observations; however there
had been other researches of FEER for future equilibrium points in exchange rates
(MacDonald 1997). According to authors’ statements, with some appropriate
counterfactual assumptions, model could also be used to calculate ex ante equilibrium
rates in addition to the ex post rates.
They conclude that, behavioral approach to identifying misalignments involves that
the level of exchange rate is sustainable as long as the values of the economic
fundamentals are also sustainable. In other words, variables of BEER are abstract and
do not have any significance as standalone. However, the actual exchange rate
returned to the statistically estimated BEER values (Clark & MacDonald 1998).
―The mirage of fixed exchange rates‖ by Maurice Obstfeld and Kenneth Rogoff also
has great influence on exchange rate studies. Obstrfeld and Rogoff decided to show
shortcoming of fixed exchange rate regime as many economies collapsed in 90s due
to pegging national currencies, e.g. the UK and Mexico are among currency crisis
faced countries (Obstfeld & Rogoff 1995). They reckon the statement that, efforts to
reform monetary institutions should focus directly on restraining domestic inflation.
The exchange rate should be used as an indicator but virtually never as the central
target for monetary policy (Obstfeld & Rogoff 1995).
They note also, a government that fixes its currency exchange rate loses control of the
domestic money supply. The main focus of this article is to give theoretical
understanding of exchange rate changes and role of government via direct or indirect
intervention.
Foreseeable future of fixed rates and adaptation of low inflation from pegged country
are mentioned as advantages of fixed exchange rate regime. However they bring
Mexico’s financial crisis as an example of not following US Dollar inflation as
written in the theory (for more information about Mexico crisis refer to the source).
26
The number of pegging countries and their successful/unsuccessful outcomes in
monetary policy led to make following conclusion: only a very small number of fixed
exchange rates had survived the past several years intact. Fixed rates normally are still
technically feasible, for most countries can easily collect the resources needed to buy
back their monetary reserves (Obstfeld & Rogoff 1995). However, present capital
markets blow up any weaknesses in a country's commitment to a fixed rate and
country has to face attack of speculation leading to high level of control.
In the field of inflation there have been plenty of researches, and they have been
connected with many other macroeconomic variable. Theoretical and empirical
analyses went deep into causes of inflation changes. For my topic inflation is one of
the variables that determine exchange rate series, I analyse inflation’s share in
alterations if currency rates as along with other determinants. I progress further within
inflation and touch the matter of Central Bank Independence (CBI). CBI index has a
direct connection to inflation, but it has significant effect to the changes of exchange
rates too. The theoretical and statistical proof of this is done by Cukierman as pioneer
in this topic. The real development of this case is carried out by Cukierman, Webb
and Neyapti in 1992 and had put initial stones for unlimited investigations within
inflation.
Their statement is ―the degree of independence of the central bank from other parts of
government affects the rates of expansion of money and credit and, through them,
important macroeconomic variables, such as inflation and the size of the budget
deficit‖. Governments often pass laws and follow customs that grant their central
banks authority and autonomy to pursue price stability, even when it conflicts with
other government objectives. The central bank's pursuit of price stability can help
reduce inflation costs. Sometimes the government has strong tendencies to focus on
issues other than price stability, in that case central bank independence and an explicit
mandate to pursue price stability are generally regarded as important institutional
devices for ensuring price stability.
The main value of this article is unified and broadly based measures of Central Bank
Independence. The legal and economical independence of central bank are combined
27
to single index. Cukierman and others formed special questionnaire with certain
weights to each answer. 72 country central banks were involved in the analysis.
Calculated index range is between 0 and1. The higher the index, the more independent
is the central bank. The lower is the CBI, the higher is the possibility if uncontrollable
inflation. The parts of the questionnaire concerned the years of election cycle,
governor turnover rates, limitations on lending, resolution of conflict and the others.
Moreover, specialists on monetary policy in 23 central banks had been given other
kind of questionnaire to identify divergence between actual and legal independence.
As the result of the answers of these questionnaires, authors state that countries with
high CBI index had less annual inflation rates, and vice versa, countries with lower
CBI index had higher price changes (Cukierman, Webb & Neyapti 1992). The top
five high CBI index countries were Germany, Switzerland, Austria, Denmark and the
USA within the range of 0,5-0,7; these countries follow the general rule: the
maximum average annual inflation observed was 5%.
But on the basis of questionnaire answers of specialists there were some countries that
present moderate CBI index although they show very stable price levels. Belgium and
Barbados are good examples of this kind of sample. Cukierman et al. mention this as
result of subjective evaluation and questionnaire-based index could contain more
noise than legal index. The authors comment that "Austria, The Bahamas, Belgium,
Luxembourg, Netherlands, and Panama have lower inflation in the 1980s than their
central bank independence would indicate, because their monetary policy is
dominated by a policy rule fixing their exchange rate to a relatively stable currency‖.
In this statement the authors are actually suggesting that the adoption of a fixed policy
rule for the exchange rate will modify the relation between central bank independence
and inflation performance. In fact, more than one-third of the developing countries in
their sample have fixed exchange rate rules. Explicit recognition of differences in
exchange rate-fixing arrangements increases the empirical support for their hypothesis
that connects central bank independence and inflation.
The CBI analysis of Cukierman was implemented for limited number of countries, but
this was fundament for further hundreds of research papers on Central Bank
Independence and Inflation. On the basis of weighting rules of answers of
28
questionnaire similar indices have been developed and applied to wider range of
countries and longer periods.
Cukierman, Webb, and Neyapti had constructed a combined measure of central bank
independence derived from a regression of their index of legal central bank
independence and the rate of turnover of central bank governors on the rate of
inflation. The further developments of similar research are not rare in academic
journals. And one of the significant and recent works is ―Central Bank autonomy:
Lessons from Global Trends‖ by Marco Arnone, Bernard Laurens, Jean-François
Segalotto, and Martin Sommer in 2007.
Arnone et al. continued CBI analysis with new approach, their work covered
worldwide scope. Legal CBI is calculated for 163 central banks, representing 181
countries as end of 2003. The methodology for assessing CBI is based on Cukierman
(Cukierman et al. 1992) and Grilli (Grilli et al. 1991). Grilli et al. distinguished
political and economic dimensions of autonomy, while Cukierman provided legal
autonomy with regard to Central Banks’ chief executive officer questionnaire. Arnone
et al. combined the two methods into one and made so called ―full index‖ CBI that
includes much more subsets than 10 as in Cukierman index. The next nuance is
comparison across counties and evolution over time. They have country groups like
advanced, emerging and developing counties; late 1980 and 2003 CBI indices to
compare. For broader information refer to full articles.
The empirical part includes correlation of CBI and inflation for the sample.
Specifically, the model specification includes trade openness, inflation in advanced
economies, the fiscal balance scaled by the depth of the domestic financial sector, the
exchange rate regime, and two alternative measures of CBI. On average, a move from
no autonomy to full autonomy increases the likelihood of maintaining low inflation by
about 50 percent. In the sample, the average autonomy of central banks in emerging
markets increased from 0.3 to about 0.7 over the past two decades, which implies an
average increase in the likelihood of low inflation by about 20 percent (Arnone et al.
2007). Eventually, they conclude that the movement toward greater Central Bank
Autonomy had paid off in terms of sustained low average inflation levels in many
emerging market and developing countries.
29
I want to go through one more article which I found important in the literature. It is
openness category, and it has great influent to the exchange rate trend. The chosen
article is written by David Romer published in 1993 with the name ―Openness and
inflation: Theory and Evidence‖. The article conveys correlation between inflation
and openness, but it is as important for exchange rates as for inflation. Unanticipated
monetary expansion leads to real exchange rate depreciation, and because the harms
of real depreciation are greater in more open economies, the benefits of unanticipated
expansion are decreasing in the degree of openness (Romer 1993).
Sample of Romer conveys post-1973 period, and involves up to 114 countries
depending on the scope of analysis. Empirical statistics includes openness, real
income per capita, revolutions and CBI index. He also divided countries into groups
to better analyze statistical outcomes. Author tested the sample for high correlation
between inflation and openness. Although the results are generally robust across
subsamples, there is no evidence that the prediction of the theory holds for the most
highly developed countries. More important, average inflation rates in these countries
are low. Outside group of highly developed countries, in contrast, average inflation
rates are high and are strongly related to openness (Romer 1993).
Further Romer gives explanations to the unexpected results of regression. The first
explanation is that openness is endogenous. The ratio of openness depends not just on
a country's size but also on the country's policy choices. The second alternative
interpretation is that the negative association between openness and inflation reflects
considerations involving the government budget and seignorage. The amount of
revenue generated by a trade tariff is increasing in the openness of the economy.
Thus, the governments of smaller countries may obtain larger fractions of their
revenues from tariffs, and may therefore rely less on other sources of revenue,
including seignorage. The result might be lower rates of inflation. According to
Romer’s conclusions, average rates of inflation are lower in smaller, more open
countries (Romer 1993). The only exception is a group of highly developed countries,
they have low average inflation rates but there is no relation to openness ratio.
30
3. EMPIRICAL ANALYSIS
3.1 Data Description and Methodology
Throughout the paper I focus on the post-Bretton Woods period 1974-2004. In the
Bretton Woods era countries agreed to coordinate their monetary policy in order to fix
their currencies with respect to gold. This implies that chosen time is a natural period
to focus on in the analysis of the exchange rate and other variables.
The sample includes 82 countries of the world. I started with 188 countries, but
unavailability of data for whole period or at all reduced the full samples size. Taking
the averages and filling empty data with averages cannot give real picture of exchange
rate changes and weight of each variable.
In my empirical analysis I use following variables:
-Nominal exchange rate: nominal exchange rate against USD
-Real exchange rate: real exchange rate against USD.
-Inflation: nominal inflation as Consumer Price index
-Openness: sum of Export and Import divided by GDP. The ready data is taken from
Penn World Tables
-Growth: per capita output (GDP) growth rate
-Terms of Trade: growth rate of Terms of Trade (Export/Import)
-Size: total GDP, to see how changes in GDP affects my dependent variable I take log
changes of GDP.
-Debt: government debt over GDP
-CBI: Central Bank Independence index, based on Cukierman (1992) and Crowe &
Meade (2008)
31
Data on the nominal exchange rate and inflation are taken from the IMF's
InternationalFinancial Statistics. GDP, GDP growth and per capita GDP growth rates
are taken from World Development Indicators of the World Bank. Debt variable is
also from World Bank’s WDI data. Terms of trade are calculated from the Exports
and Imports values of IMF International Financial Statistics. Openness variable is
from Summers-Heston Penn World Tables version 6.2 which is the latest at the date.
CBI index is provided by Christopher Crowe and Ellen Meade, who extended
Cukierman’s CBI index for other countries and presented revised version of CBI for
end of 2003.
Debt variable is ratio of General government debt to GDP, in academic papers Public
debt is being used in the same meaning as general government debt. Lane (1999) used
debt variable as constant from 1975, in other words his debt variable is debt/GDP
from 1975. But I decided to update this data, and use averages for a chosen time
period. I believe the changes in government debt have significant effects to changes in
inflation and/or consequently to exchange rate. Empirical results will show the how
significant is my assumption.
For 20 countries I could not get full data for Debt from World bank sources, but I
could find government data for some of them 20 from OECD database. But
government debt was only for central government debt, it was not sufficient for my
DEBT variable. Finally I was able to find necessary data for European countries from
EUROSTAT.
But anyway I still needed some data for Bolivia, Ghana, Macedonia, Armenia and a
couple of countries. Then I referred to national statistics, Central Bank of these
countries provided with sufficient data so that I did not have to take data from
unofficial sources.
CBI index is provided by Crowe & Meade in connection to data request by e-mail. It
includes Cukierman et al CBI index covering 1980s and updated/modified index of
Crowe&Meade for the years till 2003.
Nominal exchange rates, openness, Size as GDP are presented as log values. Inflation,
GDP Growth and Debt variables are given in percentages. Terms of Trade and Real
32
exchange rate are calculated as annual change. For chosen period all the variable are
taken as averages.
The specification of countries that lack independent exchange rate policies, which
helps to group countries in Statistical analysis, is extracted from IMF’s Exchange
Rage Arrangements and Practices of the year 2004, because my full data includes
countries up to 2003. And it will give recent pictures of country exchange rate
frameworks.
3.2 Empirical Analysis
For statistical model I use nominal exchange rate as an equation of inflation
differential and real exchange rate. For the empirical part Regression analysis is
chosen. And I will use LS method, I also intended to apply other Panel analysis
statistical methods, but unavailability of data for each year and the big volume of the
work did not allow me to take panel analysis. This will maintain the power of the
model and preciseness of the determinants. Theoretical fundaments are based on
Purchasing Power Parity (PPP) for national currencies and Barro-Gordon policy for
long run inflation rates.
Conversion of nominal exchange rates into real rate is done by the following equation:
Ri=Ei*(Pus/Pi)
Where Ri is Real exchange rate of country i against USD, Ei is nominal exchange rate
for the country i against USD from IMF database, Pus is inflation in the USA, Pi is
inflation in country i.
The log changes model of above-mentioned formula could be rewritten as:
(Lane 1999)
where
is the rate of nominal exchange rate,
the inflation rate of the USA and
is inflation rate in country i,
is
is the rate of real exchange rate. According to
equation, the rate of nominal exchange is faster, the higher is country i's inflation rate
relative to that of the USA. And there is positive relation with real exchange rate as
well.
33
From this equation it is clearly visible that if I can define determinants of country
specific equilibrium long-run inflation rate and factors that affect the long-run change
of real exchange rate, I will be able to state exactly what determines the movement in
nominal exchange rate. Now what remains is to analyze determinants of the rates of
inflation and real exchange rate.
Cukierman et al did significant research on relation of CBI index with inflation. Their
conclusion was that the lower rate if CBI, the higher rate of inflation, which means
clear negative relation (Cukierman et al 1992).
Romer (1993) researched relation of openness with inflation and had found negative
connection between them.
In 1996 Campillo and Miron made research on determinants of inflation and they
assessed inflation rate by using variables Central Bank Independence index, political
instability, Imports/GDP, Income, exchange rate regime, debt/GDP and quality of the
data. Level of income is estimated to have negative sign with inflation (Campillo &
Miron 1996). Authors state that openness and the level of income were significant, but
with negative impact. Government debt and inflation proved to have positive relation.
And the final statement was that, holding constant all the factors discussed, the level
of GDP per capita is consistently positively related to inflation.
In 1998 Clark & MacDonald performed analysis of economic fundamentals of
exchange rates, they have conducted empirical test of terms of trade, relative price of
nontrade to traded goods, net foreign assets and real interest rates on real effective
exchange rate. They released the same sign of relation as other above-mentioned
authors.
As for latest research papers, in 2008 Crowe & Meade have done analysis of Central
Bank Autonomy, and they have found less significant results between CBI and
inflation than Cukierman et al did.
To sum up, many scholars found similar relation between selected variables and
inflation. They had different level of significance in varying subgroups. In the
following section I try to analyze specific six econometric variables on exchange rate.
34
As long as my aim is to find what determines nominal exchange rate and how
significant these variables are, I focus on significance of the variables and power of
the model. My sample is 82 countries worldwide, the number of countries was defined
through statistical data collection. When data gap between years was big I dropped
that country. Many variables were available until 2005, but for the sake of some
variable like Cenral Bank Independence (CBI) index and government debt I have to
cut observed time period to 1974-2003.
In addition to considering full sample, I examine a number of subsamples. To
determine whether statistical results derive mainly from the influence of a few
extreme observations, I consider samples that omit countries with average inflation
rate more than 30%, the sample that includes countries which have data for whole
period 1974-2003 and last sample of countries which have available data only for
period 1992-2003.
Here I try to group countries and/or variable into different subgroups to get remove
noise and insignificant factors:
1. All countries, full sample;
2. Countries with average inflation rate less than 30 %
3. Countries with values for 1974-2003
4. Countries with available values for only 1992-2003
5. Former Socialistic Countries.
For all of above-mentioned subsamples I commit the following regression equation
analysis:
A. Nominal exchange rate - Inflation
B. Nominal exchange rate - Openness, Size, Growth, Terms of trade
C. Nominal exchange rate - Openness, Size, Growth, Terms of trade, Debt, CBI
index
D. Real exchange rate - Growth, Terms of trade.
For full information about variables, calculation and sources refer to data description
section.
35
Table 1. Descriptive statistics for full sample
Notes: All the variables are average annual data. CBI is Central Bank Independence index calculated
by Cukierman(1992) and Crowe&Meade(2008). Debt is Government debt over GDP, given in %.
Growth is GDP per capita average annual growth for 1974-2003 of 82 countries. Inflation is Consumer
Price index, average of yearly changes is taken. Nomxrate is average annual changes of nominal
exchange rates against USD over 1974-2003. Openness is ratio of export plus import to GDP.
Realxrate is average annual change in real exchange rate agains the USA price level for the period
1974-2003. Size is total GDP, given in average of annual percentage changes. TOT is growth rate of
terms of trade (Export/Import). Full description of variables are given in data description section.
Table 1 provides summary of descriptive statistics for all variables in the full sample.
CBI index being theoretically between 0 and 1, here it is just on the middle, 0.45.
Public Debt over GDP ratio is 56%, it is average of 82 countries for 30 years period
(1974-2003 both years including), and it is quite big compared to for recent years. The
highest indebted country Zambia has 190 % debt over total output. It is not surprising
that the minimum indebted country is Luxembourg with only 4.5%. Per capita GDP
growth has range of -4% up to +13% average annual rates. The highest average rise
has been noted in Albania, this is quite reasonable, because for small economy high
growth rates do not really mean that they are fully industrialized, these changes are
not stable. For Albania I have data starting from 1992, the average value is taken only
for 11 years then. The followers of Albania in this race are countries of South-East
Asia, known as Tigers for their recognized growth rates.
Number one important factor in this rank, Inflation variable, seems logically
acceptable, average 43.7% within the range of 0.6% - 469% shows that the weight of
economies with stable price indices is bigger. This increases power of model; it is not
analyzing extraordinary changes due to crises or wars. If I comment on exchange
rates, average annual change in nominal rates is 40%. The leaders are Bolivia, Peru
and Brazil. I accept this as correct result of statistics. Bolivia in 1982-86 years had
very high changes in exchange rates, even though it was not shocking high
depreciation, in annual change terms it could be very sensitive. Albania, Croatia and
Brazil have shown highest annual changes in real exchange rate, for Croatia and
Brazil this related to high inflation rates too.
36
In growth rate of GDP (Size), year-on-year percentage changes of constant price GDP
are taken, the base year for constant price is country-specific (IMF World Economic
Outlook). Data being constant values and average for full period, the values are not so
high. Mean GDP growth rate is 3%.
The growth rate of Terms of Trade is also not in line with expectations. It is due to
changes in Export and/or import. For instance, Uganda’s Exports increased
dramatically in 1991 and 1994, while its imports decreased slightly. These movements
set Uganda to be of highest growth rate of Terms of Trade.
As it is clear from the table 2, 14 countries out of 82 in my sample have experienced
nominal appreciation against the US Dollar over 1974-2003. Austria has shown
average annual 4.2 % appreciation over 30 years. The rest is other members of
European Monetary System and they have appraisingly stable inflation rates. The only
exceptions are Lithuania and Latvia that have 18.8% and 15.2% average annual
inflation rates. The reasons for appreciation of the two countries can be their future
involvement in EURO zone and/or effects of Euro as they trade mainly with the
countries of Euro area.
Table 2. Appreciating countries
Note: Countries that experienced nominal appreciation against USD over 1974-2003.
IMF International Financial Statistics and author’s calculations.
Table 3 exhibits the countries that are in Euro area and using Euro as national
currency. The year of entry to Euro system is given to be aware of from which date
inflation and other variables’ effects are limited. But as these countries use same
currency and European Central Bank watches over Euro changes, this has spillover
effect to other factors in my model, in other words, after euro introduction their
inflation, debt and growth variables starts converging and have similar growth rates.
Moreover, in this table the list of EU countries that pegged national currencies to EU
is very useful. It helps to understand trends in exchange rates. As theory of exchange
rates state, when country pegs to other currency, there is big change that the pegging
adopts inflation and interest rates of host country (Edwards & Losada 1994).
37
Table 3. Euro Zone countries
Note: Countries that started
using Euro or pegged to
Euro.
*these countries prior to
Euro introduction used to
peg national currencies to
Euro.
IMF. De Facto
Classification of Exchange
Rate
Regimes and Monetary
Policy Framework
Table 4. Countries with more than 30 % average annual inflation rate
Note: 22 countries that have
average annual inflation rate
bigger than 30 %, for the
period 1974-2003. Bolivia
experienced 469% average
yearly inflation within 30
year period, while Mexico
had 35%. But for former
socialistic countries the
period is 1992-2003.
IMF, International Financial
Statistics
For further analysis of empirical part from the full sample I have deducted countries
with inflation rate more than 30%. These countries are mainly for Latin America, led
by Bolivia, Peru, Brazil and Argentina with three digit inflation rates (see Table 4).
There are nine countries from former socialistic states, and they are experiencing
transition period. But I will state that transition period should have certain frames,
because by 2003 they had had 13 years of independence, and it is long enough to
overcome spillover problems of socialistic regime and apply market rules. Now
market rules are well defined and the entire infrastructure is clearly put in action,
38
moreover International organizations able to lend long term loans under beneficial
conditions.
3.3 Interpretation Of Results
Let’s start empirical result with checking my first hypothesis that inflation and
nominal exchange rate are highly correlated, which is consistency of PPP. For the full
sample of 82 countries the model fits very well, R-square 79.5 % and inflation is
significant at 99 % confidence level. The results of analysis from Eviews 5.1 can be
seen in appendix. But for the countries with the inflation less than 30% sample, the
PPP lost its significance, the model does not fit at all at R-square of 3.3%, and
variables are no more significant: t-statistic and P-value reject the significance if
inflation for this sample. I have to add that when the form of heteroskedasticity is not
known, it may not be possible to obtain efficient estimates of the parameters using
weighted least squares. OLS provides consistent parameter estimates in the presence
of heteroskedasticity, but the usual OLS standard errors will be incorrect and should
not be used for conclusion. That’s why used the White covariance estimator in place
of the standard OLS formula.
When sample of Countries with data for whole period 1974-2003is analyzed model
gets significant again, now with more power, R-square is 88.5% and t-statistic, DW
test, P-value supports this statement. For sample of Countries with data only for 19922003 the model is still significant, but with less explanation power. But for former
socialistic countries PPP does not hold, reasons can be transition periodic issues.
As long as first condition, that is applicability of PPP, holds I can continue with
further empirical works.
Now, the model is regression of nominal exchange rate on selected variables. Firstly,
the nominal exchange rate is regressed on openness, size, growth and terms of trade
variables. You can see full results of regression in appendix. I call it partial
regression, because not all the factors are included in the equation. As it is performed
for PPP model, all subsamples are analyzed one by one.
39
For the full sample, neither t-statistic, nor P-value, nor R-square (10%) is stating that
model is significant and fitting the results. D-W statistic is showing positive serial
correlation between variables. But at 10% confidence level Size variable is also
significant, but I use 5% confidence level usually in analysis.
But when I analyze partial regression for subsample of countries with inflation rates
less than 30%, then the picture is changing. The model is found to be significant
(R2=24%), but only openness and growth variables are significant at 5% confidence
level to assess nominal exchange rates. These factors are with negative sign. Size is
again significant at 10% confidence rate and it has positive sign. And DW statistic,
being equal to 2, shows no serial correlation.
For sample of Countries with data for whole period 1974-2003, the only significant
variable is growth, and it has strong negative binding to nominal exchange rates; R2 is
14% that means model can explain only 14% of changes in real data. For the rest of
the countries in included in this subsample, size is found to be significant explanatory
variable, but model itself gained 39% in R2.
For former socialistic countries partial model lost its significance, none of the selected
variables are accepted to be important (see appendix for detailed view).
At last, it is time to analyze equation of all variables determining nominal exchange
rate. Dependent variable is still nominal exchange rate. Independent ones are
openness, size, growth, terms of trade, debt and CBI index. First sample includes all
82 countries. There is almost no change from the results of partial regression. The
model explains only 10% of actual information. None of the variable is important at
5% of making error choosing all the variables significant.
However, in the sample of controlled inflation rate (less than 30%) openness and
growth factors strongly significant, alas the model fits only 24% (R2). Per capita GDP
growth rate still remains important in determining nominal exchange rates within the
countries those have data for 30 year long, and the sign of variable is always negative.
But for the countries of former socialistic regime and for those that have statistical
data only for last decade, the model is not significant.
40
The last part of empirical analysis is real exchange rate regression. In real rates
analysis I have met some unexpected results. As for Lane (1999), Growth and Terms
of trade have negative sign in relation with real exchange rates; the positive change in
independent variables should lead to real depreciation. But in my analysis, I have
changing signs of explaining variables. The terms of trade variable is consistent with
prior researches except countries of former socialistic regime. Countries of transition
period have country specific factors that could result in different outcomes. Monetary
policy and changing political system can have significant effects to the outcomes. But,
growth rate is positively effecting in full sample and in counties with less than 30%
inflation rates, also in all sample that combine data of last decade. It is negative in
sample of countries with data for whole period 1974-2003, which is consistent with
the research results of Lane in 1999. It may be the result of data and/or other problems
that lead to incorrect measurements of the real exchange rates for some countries.
The real exchange rate regression results indicate that in full sample of 82 countries,
Terms of trade variable strongly significant and the equation fits 32% of observed
data collection. In the countries with average annual interest rate less than 30%, the
model proved to be not significant. That could be because the real exchange rate
exposes relatively less volatility in developed countries.
Growth determinant is indicated as statistically significant only in the sample of
countries with full data availability for 1941-2003 and in the sample of former
socialistic states. The full indicators are given in appendix.
41
CONCLUSION
The starting point for this paper was the question ―are exchange rate fluctuations
justified by changes in their fundamental determinants‖. According to the efficient
markets theory, exchange rates are forward-looking prices that reflect anticipated
changes of the relative demand and supply of two traders. Hence, their volatility
should reflect negotiators’ expectations of changes in the determinants of money
stocks, such as incomes and interest rates. Given a model of exchange rate
determination, economic factors place restrictions on the relative volatility of
exchange rates. However my calculations showed that there are quite more variables
unidentified in the model, because determinants are significant only under some
circumstances and model does not fit actual series efficiently.
This paper presented in more detail the updated analysis of exchange rate and other
determinants outlined in Lane (1999), and also analyzed whether these factors are
related to fundamental determinants discussed in the literature and whether they have
the predicted effects.
With respect to PPP, I found a deteriorated effect of inflation on nominal exchange
rate since similar work was committed by Lane in 1999. When it comes to other
determinants, the matter of applicability of each factor really depends on the subgroup
of selected countries. For instance, when analyzing nominal exchange rates for full
sample, the model does not fit actual data and variables are found to be not
significant.
In this paper, I have investigated some determinants of long runs in nominal exchange
rates in a cross-section of countries. The model underlines two types of determinants
of nominal exchange rates: variables that affect the equilibrium long-run inflation rate
and variables that affect the long run in the real exchange rate. I established evidence
in support of both kinds of effect on the nominal exchange rate, but the evidence is
not strong to make general conclusions. Openness and per capita GDP growth
variables are significant in explaining the rate of nominal depreciation when countries
with inflation rate less than 30% are selected. For highly volatile countries Size
42
(GDP) is found to be important for assessing nominal exchange rates. The evidence
on other variables, such as CBI, Debt, Terms of trade are weaker for nominal value
estimations. However, the results for the terms of trade are turned out to be strongly
significant for estimating real exchange rates.
Despite my efforts to update the model, there is substantial improvement to be made
in achieving a better understanding of the determination of the real exchange rate. The
results of empirical analysis in appendix point out that a large fraction of the long-run
changes in nominal and real exchange rates across economies remains to be
explained. The limitations on time and data unavailability hinder to find out all
determinants of exchange rates and increase the power of estimation model.
Implication of Panel data and pool data into regression can give better understanding
of the model, but it requires combination of time series analysis and cross-section
analysis in one, which requires effort of many experts in technical support and result
interpretations.
Nevertheless, the further development of exchange rate determination model will
include more significant variables due to bigger sample of observed countries and
longer time frame of the country annual macroeconomic indicator.
43
APPENDIX
A. Summary Statistics
Descriptive statistics for full sample
Descriptive statistics for the countries with less than 30 % average inflation
Descriptive statistics for the countries with data for whole period (1974-2003)
44
Descriptive statistics for the countries with data for only period (1992-2003)
Descriptive statistics for former socialistic countries.
45
B. De Facto Exchange Rate Arrangements and Anchors of Monetary Policy
Data as of July 31, 2006. IMF.
Classification of Exchange Rate Regimes
Exchange arrangements with no separate legal tender: The currency of another country circulates
as the sole legal tender (formal dollarization), or the member belongs to a monetary or currency
union in which the same legal tender is shared by the members of the union. Adopting such
regimes implies the complete surrender of the monetary authorities' control over domestic monetary
policy.
Currency board arrangements: A monetary regime based on an explicit legislative commitment to
exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined
with restrictions on the issuing authority to ensure the fulfillment of its legal obligation. This
implies that domestic currency will be issued only against foreign exchange and that it remains fully
backed by foreign assets, leaving little scope for discretionary monetary policy and eliminating
traditional central bank functions, such as monetary control. Some flexibility may still be afforded,
depending on how strict the banking rules of the currency board arrangement are.
Conventional fixed peg arrangements: The country pegs its currency within margins of
±1 percent or less vis-à-vis another currency or a basket of currencies, where the basket is
formed from the currencies of major trading or financial partners and weights reflect the
geographical distribution of trade, services, or capital flows. The currency composites can also be
standardized, as in the case of the SDR. There is no commitment to keep the parity irrevocably. The
exchange rate may fluctuate within narrow margins of less than ±1 percent around a central rate—or
the maximum and minimum value of the exchange rate may remain within a narrow margin of
2 percent—for at least three months. The monetary authority maintains the fixed parity through direct
intervention (i.e., via sale/purchase of foreign exchange in the market) or indirect intervention (e.g., via
the use of interest rate policy, imposition of foreign exchange regulations, exercise of moral suasion
that constrains foreign exchange activity, or through intervention by other public institutions).
Pegged exchange rates within horizontal bands: The value of the currency is maintained within
certain margins of fluctuation of more than ±1 percent around a fixed central rate or the margin
between the maximum and minimum value of the exchange rate exceeds 2 percent. As in the case
of conventional fixed pegs, reference may be made to a single currency or a currency composite.
Crawling pegs: The currency is adjusted periodically in small amounts at a fixed rate or in
response to changes in selective quantitative indicators, such as past inflation differentials vis-àvis major trading partners, differentials between the inflation target and expected inflation in
major trading partners. The rate of crawl can be set to adjust for measured inflation or other
indicators (backward looking), or set at a preannounced fixed rate and/or below the projected inflation
differentials (forward looking).
Exchange rates within crawling bands: The currency is maintained within certain fluctuation
margins of at least ±1 percent around a central rate—or the margin between the maximum and
minimum value of the exchange rate exceeds 2 percent—and the central rate or margins are
adjusted periodically at a fixed rate or in response to changes in selective quantitative indicators.
The degree of exchange rate flexibility is a function of the band width. Bands are either symmetric
around a crawling central parity or widen gradually with an asymmetric choice of the crawl of upper
and lower bands (in the latter case, there may be no preannounced central rate).
Managed floating with no predetermined path for the exchange rate: The monetary authority
attempts to influence the exchange rate without having a specific exchange rate path or target.
Indicators for managing the rate are broadly judgmental (e.g., balance of payments position,
international reserves, parallel market developments), and adjustments may not be automatic.
Intervention may be direct or indirect.
Independently floating: The exchange rate is market-determined, with any official foreign exchange
market intervention aimed at moderating the rate of change and preventing undue fluctuations in the
exchange rate, rather than at establishing a level for it.
46
Exchange Rate Arrangements
I. Fixed exchange arrangements with no separate legal tender (41)
1a. Another currency as legal tender (9)
Ecuador
Marshall Islands
Panama
El Salvador4
Micronesia, Fed. States of
San Marino
Kiribati
Palau
Timor-Leste, Dem. Rep. of
1b. ECCU (6)3
Antigua and Barbuda
Grenada*
St. Lucia
Dominica*
St. Kitts and Nevis
St. Vincent and the Grenadines
1c. WAEMU (7)
Benin*
Côte d'Ivoire
Niger*
Burkina Faso*
Guinea-Bissau
Senegal
Mali*
Togo
1d. CFA franc zone (14)
Cameroon*
Chad*
Equatorial Guinea
Central African Rep.
Congo, Rep. of*
Gabon
1e. Euro area (12)
Austria
Germany
Luxembourg
Belgium
Greece
Netherlands
Finland
Ireland
Portugal
France
Italy
Spain
2. Currency board arrangements (7)
Bosnia and Herzegovina
Bulgaria*
Djibouti
Brunei Darussalam
Hong Kong SAR
Estonia5 Lithuania5
3. Pegged (fixed) rate systems
3a. Peg against a single currency (47)
Honduras*†7
Mauritania7Namibia
Solomon Islands7
Iraq*7
Nepal*
Suriname7, 9Swaziland
Jordan7
Netherlands Antilles
Syrian Arab Rep.9
Kuwait
Oman
Trinidad and Tobago7
Latvia5
Pakistan†7
Turkmenistan7
Lebanon7
Qatar
Ukraine7
Lesotho
Rwanda*
United Arab Emirates
Macedonia, FYR*7
Saudi Arabia
Venezuela, Rep. Bolivariana de
Maldives
Seychelles7
Vietnam7
Malta5
Sierra Leone*7
Zimbabwe9
3b. Peg against a composite (5)
Fiji
Libyan Arab Jamahiriya
Morocco
Samoa
Vanuatu
3c. Pegged exchange rates within horizontal bands(6)12
3d. Within a cooperative arrangement (4)
Cyprus5 Denmark5
Slovak Rep.†5
Slovenia5
Hungary†
Tonga
3e. Other band arrangements (2)
3f. Crawling pegs (5)
Azerbaijan7 Botswana9
Costa Rica Iran, I.R. of7, 13 Nicaragua*
4. Managed floating with no pre-determined path for the exchange rate (51)
Afghanistan, I.R. of*
Haiti7
Papua New Guinea7Paraguay*
India
Algeria
Peru*
Jamaica7
Romania
Angola
47
Argentina
Armenia*7
Bangladesh*
Burundi*
Cambodia
Kazakhstan
Kenya*
Kyrgyz Rep.*
Lao P.D.R.9
Colombia*
Croatia*
Liberia7
Madagascar*7
Malawi*
Malaysia
Czech Rep.
Mauritius
Dominican Rep.*
Gambia, The7
Georgia*
Moldova*
Mongolia
Mozambique*7
Ghana*7
Guatemala7
Guinea7
Russian Federation
São Tomé and Príncipe*
Serbia, Rep. of14
Singapore
Sri Lanka7
Sudan
Tajikistan
Thailand
Tunisia
Uruguay*
Uzbekistan9
Yemen, Rep. of7
Zambia*
Myanmar
Nigeria7
5. Independently floating (25)
Albania*
Australia
Brazil
Canada
Chile
Congo, Dem. Rep. of
Iceland
Israel
Japan
Korea
Mexico
New Zealand
Norway
Philippines
Poland
Somalia9, 15
South Africa
Sweden
Switzerland
Tanzania*7
Turkey*
Uganda
Indonesia
United Kingdom
United States
Notes:
1 An asterisk (*) indicates that the country has an IMF-supported or other monetary program. A dagger
(†) indicates that the country adopts more than one nominal anchor in conducting monetary policy (it
should be noted, however, that it would not be possible, for practical reasons, to include in this table
which nominal anchor plays the principal role in conducting monetary policy).
2 Includes countries that have no explicitly stated nominal anchor, but rather monitor various indicators
in conducting monetary policy.
3 The ECCU has a currency board arrangement.
4 The printing of new colones, the domestic currency, is prohibited, but the existing stock of colones
will continue to circulate along with the U.S. dollar as legal tender until all colón notes wear out
physically.
5 The member participates in the ERM II.
6 On July 21, 2005, China announced a 2.1% revaluation of the renminbi-U.S. dollar exchange rate and
a change in its exchange rate arrangement to allow the value of the renminbi to fluctuate based on
market supply and demand with reference to an undisclosed basket of currencies. To permit a greater
role for market forces in determining the renminbi exchange rate, steps have been taken since July
2005 to liberalize and develop China's foreign exchange markets, including the establishment of an
48
over-the-counter spot foreign exchange market and markets for currency swaps and futures. From endJuly 2005 to end-July 2006, the renminbi exchange rate was more flexible, but the fluctuation in the
renminbi-U.S dollar exchange rate was less than the 2% range (for a three-month period) used in the
IMF's de facto exchange rate classification system as an indicator for a conventional fixed peg
exchange rate arrangement.
7 The regime operating de facto in the country is different from its de jure regime.
8 There is no evidence of direct intervention by the authorities in the foreign exchange market.
9 The member maintains an exchange arrangement involving more than one foreign exchange market.
The arrangement shown is that maintained in the major market.
10 This is a de facto classification resulting from the methodology described in Appendix II of this
document. The Bolivian authorities consider their regime as a crawling peg and have not committed to
the current level of the exchange rate.
11 Comoros has the same arrangement with the French Treasury as the CFA franc zone countries.
12 The bands for these countries are as follows: Cyprus ±15%, Denmark ±2.25%, Hungary ±15%,
Slovak Republic ±15%, Slovenia (undisclosed), and Tonga ±5%.
13 The rial crawls vis-à-vis an unannounced basket of currencies.
14 While the current monetary framework is anchored by the announcement of core inflation
objectives, the National Bank of Serbia is preparing the transition to full-fledged inflation targeting.
15 Insufficient information on the country is available to confirm this classification, and so the
classification of the last official consultation is used.
49
C. Inflation rates in graphs for two time periods.
Average annual inflation, 1974-2003
500
Bolivia
Peru
450
400
Brazil
350
Argentina
300
250
Ukraine
200
Croatia
150
100
50
0
Average annual inflation, 1990-2003
700
Brazil
Peru
600
500
Ukraine
400 Armenia
Belarus
300
Croatia
200
Kazakhstan
100
0
Source: IMF, International Financial Statistics
50
D. PPP regression results
Dependent Variable: NOMXRATE
Method: Least Squares
Date: 06/30/08 Time: 18:59
Sample: Full sample
Included observations: 82
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
-0.003224
0.053480
-0.060280
0.9521
INFLATION
0.009379
0.000532
17.61645
0.0000
R-squared
0.795050
Mean dependent var
0.406706
Adjusted R-squared
0.792488
S.D. dependent var
0.957191
S.E. of regression
0.436033
Akaike info criterion
1.201892
Sum squared resid
15.21001
Schwarz criterion
1.260592
F-statistic
310.3395
Prob(F-statistic)
0.000000
Log likelihood
-47.27756
Durbin-Watson stat
2.280122
Dependent Variable: NOMXRATE
Method: Least Squares
Date: 06/30/08 Time: 17:30
Sample: Countries with inflation less than 30%
Included observations: 59
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
0.021307
0.084096
0.253369
0.8009
INFLATION
0.010263
0.007382
1.390168
0.1699
R-squared
0.032793
Mean dependent var
0.118609
Adjusted R-squared
0.015824
S.D. dependent var
0.360934
S.E. of regression
0.358067
Akaike info criterion
0.817118
Sum squared resid
7.308088
Schwarz criterion
0.887543
F-statistic
1.932566
Prob(F-statistic)
0.169883
Log likelihood
Durbin-Watson stat
-22.10498
2.077757
51
Dependent Variable: NOMXRATE
Method: Least Squares
Date: 06/30/08 Time: 17:38
Sample: Countries with data for whole period 1974-2003
Included observations: 64
Variable
C
INFLATION
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
Coefficient
Std. Error
t-Statistic
Prob.
0.014374
0.010328
0.049209
0.000474
0.292108
21.78598
0.7712
0.0000
0.884464
0.882600
0.363096
8.174018
-24.95855
2.048761
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
0.428592
1.059714
0.842455
0.909920
474.6287
0.000000
Dependent Variable: NOMXRATE
Method: Least Squares
Date: 06/30/08 Time: 17:39
Sample: Countries with data only for 1992-2003
Included observations: 19
Variable
C
INFLATION
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
Coefficient
Std. Error
t-Statistic
Prob.
0.135759
0.003217
0.117097
0.001367
1.159372
2.352854
0.2623
0.0309
0.245649
0.201275
0.388053
2.559944
-7.917523
1.960633
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
0.314735
0.434202
1.043950
1.143364
5.535924
0.030932
52
Dependent Variable: NOMXRATE
Method: Least Squares
Date: 06/30/08 Time: 17:39
Sample: Former socialistic countries
Included observations: 15
Variable
C
INFLATION
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
Coefficient
Std. Error
t-Statistic
Prob.
0.178471
0.001851
0.129115
0.001641
1.382269
1.127726
0.1902
0.2798
0.089111
0.019042
0.378795
1.865317
-5.649433
2.498344
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
0.273528
0.382454
1.019924
1.114331
1.271766
0.279820
53
E. Partial regression results (nominal exchange rate: openness, size, growth,
terms of trade)
Dependent Variable: NOMXRATE
Method: Least Squares
Date: 07/01/08 Time: 16:05
Sample: Full sample. All countries
Included observations: 82
White Heteroskedasticity-Consistent Standard Errors & Covariance
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
OPENNESS
SIZE
GROWTH
TOT
0.951666
1.777013
-0.065591
-7.395440
1.395836
0.332633
4.993530
0.039375
4.491965
1.261307
2.861006
0.355863
-1.665794
-1.646371
1.106659
0.0054
0.7229
0.0998
0.1038
0.2719
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.104445
0.057923
0.929055
66.46209
-107.7394
1.847995
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
0.406706
0.957191
2.749741
2.896492
2.245056
0.071837
Dependent Variable: NOMXRATE
Method: Least Squares
Date: 07/01/08 Time: 16:11
Sample: Counttries with inflation rate less than 30%
Included observations: 59
White Heteroskedasticity-Consistent Standard Errors & Covariance
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
OPENNESS
SIZE
GROWTH
TOT
0.553613
-2.583044
0.036033
-8.876816
0.925128
0.224881
1.255172
0.019996
3.819293
1.420891
2.461806
-2.057921
1.801945
-2.324204
0.651090
0.0170
0.0444
0.0771
0.0239
0.5177
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.237685
0.181217
0.326597
5.759953
-15.08244
2.049671
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
0.118609
0.360934
0.680761
0.856823
4.209206
0.004874
54
Dependent Variable: NOMXRATE
Method: Least Squares
Date: 07/01/08 Time: 16:14
Sample: Countries with data for whole period 1974-2003
Included observations: 64
White Heteroskedasticity-Consistent Standard Errors & Covariance
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
OPENNESS
SIZE
GROWTH
TOT
1.601053
2.034186
-0.017525
-20.40241
0.833158
0.670056
9.528442
0.064918
10.50969
1.559880
2.389433
0.213486
-0.269952
-1.941295
0.534117
0.0201
0.8317
0.7881
0.0570
0.5953
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.139315
0.080964
1.015909
60.89223
-89.21919
1.836737
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
0.428592
1.059714
2.944350
3.113012
2.387518
0.061137
Dependent Variable: NOMXRATE
Method: Least Squares
Date: 07/01/08 Time: 16:16
Sample: Countries with data only for 1992-2003
Included observations: 19
White Heteroskedasticity-Consistent Standard Errors & Covariance
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
OPENNESS
SIZE
GROWTH
TOT
0.502415
2.702377
-0.083961
-1.249153
0.679225
0.173897
2.235080
0.040123
3.815529
1.653303
2.889159
1.209074
-2.092587
-0.327387
0.410829
0.0119
0.2467
0.0551
0.7482
0.6874
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.392706
0.219193
0.383676
2.060896
-5.857502
1.515398
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
0.314735
0.434202
1.142895
1.391432
2.263267
0.114210
55
Dependent Variable: NOMXRATE
Method: Least Squares
Date: 07/31/08 Time: 16:18
Sample: Former socialistic countries
Included observations: 15
White Heteroskedasticity-Consistent Standard Errors & Covariance
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
OPENNESS
SIZE
GROWTH
TOT
0.487945
3.523297
-0.084124
-0.729252
-0.096281
0.218039
3.736853
0.076680
5.616108
2.278407
2.237884
0.942851
-1.097074
-0.129850
-0.042258
0.0492
0.3680
0.2983
0.8993
0.9671
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.273029
-0.017760
0.385835
1.488690
-3.957924
1.911023
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
0.273528
0.382454
1.194390
1.430407
0.938925
0.480224
56
F. Regression results for equation with all variables
Dependent Variable: NOMXRATE
Method: Least Squares
Date: 07/01/08 Time: 17:40
Sample: Full sample. All countries
Included observations: 82
White Heteroskedasticity-Consistent Standard Errors & Covariance
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
OPENNESS
SIZE
GROWTH
TOT
DEBT
CBI
1.080066
1.863120
-0.068304
-7.275685
1.333675
8.01E-05
-0.291582
0.539179
5.155551
0.040979
4.466445
1.283786
0.002919
0.658787
2.003169
0.361381
-1.666797
-1.628966
1.038861
0.027429
-0.442604
0.0488
0.7188
0.0997
0.1075
0.3022
0.9782
0.6593
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.106273
0.034775
0.940400
66.32647
-107.6556
1.837435
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
0.406706
0.957191
2.796479
3.001930
1.486369
0.194410
Dependent Variable: NOMXRATE
Method: Least Squares
Date: 07/01/08 Time: 17:41
Sample: Countries with inflation rate less than 30%
Included observations: 59
White Heteroskedasticity-Consistent Standard Errors & Covariance
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
OPENNESS
SIZE
GROWTH
TOT
DEBT
CBI
0.692719
-2.076372
0.026488
-8.862647
0.829448
-0.001090
-0.130474
0.469249
0.827555
0.017006
3.888748
1.520720
0.002073
0.240927
1.476230
-2.509045
1.557573
-2.279049
0.545431
-0.525526
-0.541549
0.1459
0.0153
0.1254
0.0268
0.5878
0.6015
0.5904
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.242992
0.155645
0.331658
5.719848
-14.87632
1.983815
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
0.118609
0.360934
0.741570
0.988058
2.781919
0.020157
57
Dependent Variable: NOMXRATE
Method: Least Squares
Date: 07/01/08 Time: 17:55
Sample: Countries with data for whole period 1974-2003
Included observations: 64
White Heteroskedasticity-Consistent Standard Errors & Covariance
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
OPENNESS
SIZE
GROWTH
TOT
DEBT
CBI
2.010467
2.899399
-0.023513
-23.46020
0.612283
-0.003225
-0.076583
0.906728
9.918590
0.075574
10.46549
1.612297
0.003535
1.117356
2.217275
0.292320
-0.311134
-2.241673
0.379758
-0.912420
-0.068539
0.0306
0.7711
0.7568
0.0289
0.7055
0.3654
0.9456
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.146912
0.057114
1.029007
60.35475
-88.93548
1.778620
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
0.428592
1.059714
2.997984
3.234112
1.636018
0.153972
Dependent Variable: NOMXRATE
Method: Least Squares
Date: 07/01/08 Time: 17:58
Sample: Countries with data only for 1992-2003
Included observations: 19
White Heteroskedasticity-Consistent Standard Errors & Covariance
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
OPENNESS
SIZE
GROWTH
TOT
DEBT
CBI
0.766292
3.181323
-0.077494
-1.932745
0.921894
-0.002243
-0.240671
0.855670
2.415934
0.059607
3.814615
2.196621
0.002896
1.398590
0.895547
1.316809
-1.300084
-0.506668
0.419687
-0.774445
-0.172081
0.3881
0.2125
0.2180
0.6216
0.6821
0.4537
0.8662
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.416056
0.124084
0.406372
1.981655
-5.485020
1.384427
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
0.314735
0.434202
1.314213
1.662164
1.424986
0.282753
58
Dependent Variable: NOMXRATE
Method: Least Squares
Date: 07/31/08 Time: 18:00
Sample: Former socialistic countries
Included observations: 15
White Heteroskedasticity-Consistent Standard Errors & Covariance
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
OPENNESS
SIZE
GROWTH
TOT
DEBT
CBI
0.666117
3.023846
-0.049456
1.477821
-1.191895
0.003394
-0.831863
0.531490
4.036747
0.094916
6.967397
2.913842
0.003304
0.810211
1.253301
0.749080
-0.521050
0.212105
-0.409046
1.027340
-1.026723
0.2455
0.4753
0.6164
0.8373
0.6932
0.3343
0.3346
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.330730
-0.171222
0.413903
1.370528
-3.337674
2.204528
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
0.273528
0.382454
1.378356
1.708780
0.658888
0.685516
59
G. Real exchange rate regression results.
Dependent Variable: REALXRATE
Method: Least Squares
Date: 07/01/08 Time: 18:27
Sample: Full sample, all countries
Included observations: 82
White Heteroskedasticity-Consistent Standard Errors & Covariance
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
GROWTH
TOT
1.199289
1.804425
-18.73067
0.736588
13.87922
2.952579
1.628168
0.130009
-6.343836
0.1075
0.8969
0.0000
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.324020
0.306907
1.886633
281.1914
-166.8779
1.635203
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
0.900239
2.266166
4.143364
4.231415
18.93371
0.000000
Dependent Variable: REALXRATE
Method: Least Squares
Date: 07/01/08 Time: 18:51
Sample: Countries with inflation rate less than
30%
Included observations: 59
White Heteroskedasticity-Consistent Standard Errors & Covariance
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
GROWTH
TOT
-0.440448
17.70952
-14.69977
1.065689
20.29256
10.15322
-0.413299
0.872710
-1.447795
0.6810
0.3865
0.1533
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.162364
0.132449
1.223834
83.87509
-94.09521
1.536247
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
0.481601
1.313938
3.291363
3.397001
5.427424
0.007007
60
Dependent Variable: REALXRATE
Method: Least Squares
Date: 07/01/08 Time: 18:51
Sample: Countries with data for whole period 1974-2003
Included observations: 64
White Heteroskedasticity-Consistent Standard Errors & Covariance
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
GROWTH
TOT
1.985088
-19.31242
-18.26722
0.686900
9.837588
3.073131
2.889921
-1.963126
-5.944171
0.0053
0.0542
0.0000
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.495486
0.478945
1.399763
119.5195
-110.7992
1.901574
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
0.394438
1.939155
3.556224
3.657422
29.95422
0.000000
Dependent Variable: REALXRATE
Method: Least Squares
Date: 07/01/08 Time: 18:56
Sample: Countries with data only for period
1992-2003
Included observations: 19
White Heteroskedasticity-Consistent Standard Errors & Covariance
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
GROWTH
TOT
1.420306
25.53575
-3.759347
0.815727
15.17821
11.84641
1.741154
1.682395
-0.317341
0.1008
0.1119
0.7551
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.208739
0.109832
2.304792
84.99303
-41.19207
1.236937
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
2.606101
2.442843
4.651797
4.800919
2.110449
0.153658
61
Dependent Variable: REALXRATE
Included observations: 15 Sample: Former socialistic countries
White Heteroskedasticity-Consistent Standard Errors & Covariance
Variable
Coefficient
Std. Error
C
0.837918
0.635537
GROWTH
21.31633
8.089837
TOT
6.412807
12.57028
R-squared
0.181387 Mean dependent var
Adjusted R-squared
0.044952 S.D. dependent var
S.E. of regression
1.708044 Akaike info criterion
Sum squared resid
35.00898 Schwarz criterion
Log likelihood
-27.64074 F-statistic
Durbin-Watson stat
1.204691 Prob(F-statistic)
t-Statistic
1.318440
2.634952
0.510156
Prob.
0.2120
0.0218
0.6192
1.998607
1.747779
4.085431
4.227041
1.329472
0.300934
62
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