IMPACT OF MACROECONOMIC VARIABLES ON EXCHANGE
RATES
INTRODUCTION
Exchange Rate can be defined as the rate at which the local currency of one country
can be exchanged for another currency. In certain cases these currencies may be
sub-national as is in the case of Hong Kong and in certain cases it may be
supra-national as is in the case of the euro. The Exchange Rate is one of the most
widely examined and analyzed financial variables which is operated by the government
and is a key economic determinant for trade and capital flow dynamics. The Exchange
Rate apart from being a facilitator of international trade for imports and exports is also a
very useful macroeconomic variable which is utilized as a parameter for deciding the
strength and position of economy of a country worldwide. Exchange Rate is a key
indicator of the economic health and level of trade. The higher the exchange rate is, the
lower the trade balances. Whereas a lower exchange rate would increase the trade
balance of a country.
Since the exchange rate is a very important and critical macroeconomic variable in a
free market economy therefore it is extremely important to understand the impact of
other macroeconomic variables on exchange rate and control the system in such a
manner that the fluctuations in the macroeconomic variables does not cause sudden
changes in the exchange rates and in turn does not disbalance the market performance.
As exchange rates are relative and are expressed as a comparison of the currencies of
two countries it is very intuitive to understand that macroeconomic factors which affect
and are indicators of the economic health of a country will have an impact on the
exchange rate too. Some of the macroeconomic factors which are key determinants of
the exchange rate are consumer price index (differentials in inflation), differentials in
interest rates, gross domestic product (GDP growth), currents accounts deficits, balance
of trade, public debt etc.
Some of the macroeconomic variables which are determinants of the exchange rate like
gross domestic products (GDP growth), consumer price index (inflation), gross national
product (GNP) and industrial and manufacturing productions are also ky economic and
financial factors which are used to classify countries into two major groupings, knows as
developed and developing countries. In this paper we will see the impact, correlation
and causation of the various macroeconomic factors mentioned on the exchange rates,
in the purview of both developed and developing countries.
LITERATURE REVIEW
On studying the different literature present on the impact of macroeconomic factors on
the exchange rate it is evident that the impact and relation of these factors with
exchange rate has been a matter of great interest for economists for some time now.
Among the macroeconomic factors, few variables such as GDP growth, inflation and
interest rates are most favourite macroeconomic variables for researchers and
economists to explore the relationship with exchange rate. Apart from the above
variables other factors like exports, imports, Stock price index, metal prices,
manufacturing and industrial production and monetary supply are also widely studied to
explore their relationship with exchange rate.
Despite there being several papers on the impact of macroeconomic factors on
exchange rate there is no clear consensus about these relations and the results from
market actually vary from each research paper to another and in certain cases
contradict economic theory especially in developing markets motivating economists to
explore new factors which might have considerable influence on the exchange rate.
Fraz and Fatima (2016) explored the relationship of GDP growth, inflation and interest
rates with the exchange rates in both developed and emerging markets with great
potential. Their results showed that in developed countries like Japan and the UK
interest rate was the only macroeconomic variable which had a significant relationship
with exchange rate while there was no significant relation between the other two
macroeconomic variables i.e GDP growth and inflation with exchange rate. Interestingly
Japan apart from having strong and positive correlation between interest rate and
exchange rate it also had a negative but weak correlation between inflation and
exchange rate. In the developing markets of India and South Africa they found a strong
correlation between the inflation and exchange rate. Apart from this they also found a
strong unidirectional causality existing from inflation and interest rate on the exchange
rate. Overall they concluded that the macroeconomic factors of GDP growth, inflation
and interest rate had a strong influence on the fluctuation of exchange rates in both
developing and developed markets.
Ramasamy (2015) talks about the impact of the existence of corrupt practices on the
exchange rates. On studying economically sound and less corrupt countries the results
contradict expected results. Results showed that interest rate and inflation impacted the
exchange rate negatively in these markets but according to theory they should have
positively impacted the exchange rate. The explanation proposed for this variation was
that the relative strength of the currency in these countries was derived from the
confidence of the investors and public and not from economic variables prevailing in
these countries. Also these countries having stable interest rates, less corrupt practices
and least unemployment rates were proposed as reasons for the result being
diametrically opposite to theory based results. Hence the overall conclusion that was
drawn was that in the context of developed markets the inclusion of psychological
factors such as the confidence of investors and traders on the stability of these
economies is imperative to comprehend the actual impact of macroeconomic factors on
the exchange rate.
RESULTS AND DISCUSSION
In this section we will individually analyse the impacts of certain major macroeconomic
factors on the exchange rate and try to validate whether these variables have a
significant relationship with exchange rate.
GDP Growth
Figure 1-GDP Per capita and Real Exchange Rate
Source: Jean Foure (2012)
From the above graph it is very evidently visible that GDP growth has a positive
correlation with the exchange rate. But the significance of this relation is not definite.
The relationship between GDP growth rate and the exchange rate has a very large
dependency on the time period of observation and the country of observation. There are
multiple exchange rate determination theories like the monetary approach to exchange
rates which predicts that higher the GDP growth rate higher is the value of a country’s
currency which translates to a positive impact on the exchange rate of the county. But
actual market statistics vary from these exchange rate determination theories. The
correlation between GDP and exchange rate has a very high dependency on the type of
economy existing in the country. In the case of a developed market the correlation
between GDP growth rate and the exchange rate is very low whereas in the case of
developing economies the GDP growth rate has a relatively stronger correlation with the
exchange rate although still not having very high significance levels. Despite the
correlation, a study of most major developed and developing countries points towards
the absence of any causal relationship existing between the GDP growth rate and the
exchange rate.
Consumer Price Index (Inflation)
Table 1: Autoregressive Lag Distributes Of CPI, Interest Rate and EXR
Source: Thaddeus and Nnneka (2014) and own calculations
From the table and from the equation 1 given below it we can see that at the 5%
significance level, the consumer price index (differential in inflation) has a positive and
significant influence on the exchange rate. This significant correlation between the
Consumer Price Index and the exchange rate exists in both developing and developed
countries. This correlation can be very simply explained by the fact that inflation is a
direct derivative of the purchasing power parity of a country therefore in the case where
two countries do not have the same purchasing power parity the inflation rate will have
a significant influence on the exchange rate. In such a scenario where a country has
higher inflation rate the currency with the higher inflation rate will start losing value and
depreciating while on the other hand the currency with the lower inflation rate will start
appreciating on the Forex market thus influencing the exchange rate in a positive
manner.
Figure 2-Relationship Between Real Exchange Rate and Inflation
Source: Araujo and Filho (2017)
The line plot in figure 2 very elegantly shows the similar trajectory that inflation and
exchange rate followed for the period of 1999-2015. The similar trajectory of both the
line plots is an indication towards the fact that the Consumer Price Index has a very
significant positive influence on the exchange rate and any fluctuation in the inflation
rate impacts the exchange rate.
Interest Rate
Figure 3-Relationship Between Swiss Interest Rate and Exchange Rate
Source: VoxEU
Figure 4-Standard Deviation of Exchange Rate Volatility with Interest Rate in
Different Countries
Source: VoxEu
In figure 3 we can see that the trajectory followed by the line plot of interest rate is
loosely followed by the exchange rate line plot too. This is an indication towards the fact
that the interest rate has an influence on the exchange rate but this relationship
between the interest rate and the exchange rate is very insignificant for it to have any
real impact on the market scenario. A drastic fluctuation in interest rates leads to a
minor drop in the exchange rate alluding to the insignificant correlation existing between
the interest rate and the exchange rate. This hypothesis is supported by the numbers
that we see in Table 1 from which we can clearly see that the interest rate influences
the exchange rate negatively although insignificantly. This statement is supported by the
t-ratio of -0.1239 and probability of 0.902. The negative relation between interest rate
and exchange rate can be very easily explained by the reasoning that a lower interest
rate implies that there is lesser money to be made by investing in the country’s asset as
it yields a lesser interest which has a direct negative impact on the Foreign Direct
Investment and other sources of foreign capital leading to the country’s currency getting
devalued on the Forex. Whereas increasing interest rate projects the country as a viable
investment opportunity for foreign investors and as a result foreign capital flows into the
country leading to the appreciation of the country’s currency in the Forex market thus
impacting the exchange rate negatively.
Even in figure 4 we can see that in most countries the standard deviation in the
exchange rates is extremely less which shows an insignificant relation between the
interest and the exchange rate. The only exceptions are the US and Japan which show
a significant relation between the exchange rate and the interest rate.
Trade Balance
Figure 5-Relationship Between Exchange Rate and Trade Balance in Croatia
Source : IMF E-library
The study of both developing and developed markets indicates the fact that trade
balance and the exchange rate have a very significant relationship.This thought process
is even validated by numbers. On running Correlation tests between trade balance
numbers and the exchange rate the numbers show a very significant relation between
the trade balance and exchange rate. Apart from correlation there also exists a
bidirectional causality between trade balance and exchange rate. The fact that balance
of trade has a significant impact on the exchange rate has at it’s crux the fact that
supply and demand can lead to appreciation or depreciation of currencies. A country
which has a high demand for its goods naturally tends to export more than it imports,
increasing the demand for its currency thus positively impacting the exchange rate.
Similarly a country that imports more than it exports will have lesser demand for its
currency thus negatively impacting its exchange rate.
CONCLUSION AND SUMMARY
On studying the impact of the major macroeconomic variables on the exchange rates
the following conclusions can be drawn :
● The GDP growth’s impact on the exchange rate has a very high dependency on
the time period of analysis and the countries in which we are conducting the
research. In developed countries the impact of the GDP growth rate on the
exchange rate is very low as these countries have a sustained and stable growth
rate and as a result the exchange rate works more in tandem with the investor
sentiments in the country and confidence of the public in their own currency. In
developing countries the impact of the GDP growth rate on the exchange rate is
relatively stronger. As the developing countries do not have a GDP growth rate
as stable as the developed nations therefore a positive GDP growth rate
indicates a flourishing economy which ignites confidence in foreign investors to
invest in these countries thus attracting foreign capital and leading to a positive
impact on the exchange rate.
● The Consumer Price Index (inflation) has a positive and significant relation with
the exchange rate. This is true in the cases of both developing and developed
countries. Moreover in most developing countries it has been found that the
inflation rate has a unidirectional causal relation with the exchange rate. The
possible reason for the causality being insignificant in developed and much more
pronounce in developing countries can be the fact that the inflation rate in the
developed countries is less than or around the same value as the global average
which the exchange rate is already adjusted for but in the case of developing
nations the inflation rate is much higher than the global inflation rate and as a
result it has a very strong correlation and causation on the exchange rate. The
inflation rate impacts the exchange rate and the economy in general via its
impact on multiple macroeconomic variables some of which are Purchasing
Power Parity (PPP) and interest rate. Due to the large scale impact on the
economy and exchange rate due to the fluctuations in the inflation rate it is
imperative for policy makers to keep a close monitoring on the inflation rate in
their countries and take required proactive measures to prevent drastic
fluctuations in the inflation rate.
● Interest rate was found to have a negative but very insignificant relation with the
exchange rate. This is especially true in the case of developed nations. While in
certain developing nations like India and Brazil the interest rate was seen to have
a long term causal relationship with interest rate. In the context of the Indian
market interest rate having a causal impact on the exchange rate is very intuitive
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to understand. In the Indian market borrowing and credit are major operatives by
which the government controls cash flow, so in the scenario where interest rates
are hiked borrowing would reduce and as a result cash flow would also decrease.
This will result in a lesser demand for the country’s currency thus impacting the
exchange rate in a negative manner.
Balance of trade and exchange rate were shown to have very significant positive
correlation with each other. They also had a bidirectional causality existing
between the two in both developing and developed countries. Considering the
direct impact that the balance of trade has on exchange rate it is extremely
necessary for policy makers in developing countries to keep their trade deficit in
check. It is in their interest to reduce the trade deficit by as much as possible as it
would consequently lead to greater demand for their currency which would have
a positive impact on the exchange rate and also be a major economic boost.
Apart from these macroeconomic factors there were certain other factors which
were seen to have an impact on the exchange rate.
In the developed nations, the GDP growth rates, inflation rates and interest rates
are very stable and even the trade balance, although not stable to the same
degree but always positive, has a muted impact on the exchange rate. In such a
scenario the investor sentiments and the confidence of the public in their
currency is also a major impact creator on the exchange rate in these countries.
In developing nations the prevalence of corrupt practices has a negative
correlation with the exchange rate. In a country with rampant corruption foreign
investors are sceptical about investing their money because of the malpractices
involved and as result the inflow of foreign capital in such countries is less than
what they would have been in normal scenarios. The reduction in the influx of
foreign capital leads to the depreciation of the country’s currency leading to a
negative impact on the exchange rate.
REFERENCES
● S.Fatima and T.Fraz, “EXPLORING THE IMPACT OF MACRO ECONOMIC
VARIABLES ON EXCHANGE RATES : A Case of some Developed and
Developing Countries”, Pakistan Journal of Applied Economics, 2016
● R. Ramasamy, “Influence of Macroeconomic Variables on Exchange Rates”,
Journal of Economics, Business and Management”, 2015
● J.Foure, “The Great Shift: Macroeconomic Projections for the World Economy at
the 2050 Horizon”, SSRN Electronic Journal, 2012
● Thaddeus and Nnneka, “Exchange Rate, Inflation and Interest Rates
Relationships : An Autoregressive Distributed Lag Analysis”, Journal of
Economics and Development Studies, 2014