What are the short and long-term determinants of exchange rates?

Area and context of research
For many years, the fluctuation of exchange rate has always been an interesting topic for manyresearchers. Most economists think that the volatility of exchange rates are driven 英國dissertation網bymacroeconomicphenomena (Rose, 1994). However, since the 1980s, many researchers have thrown doubt on theexplanation of exchange rate using macroeconomic model. Flood and Rose (1995) said that theexchange rate ‘appears to have a life of its own’. This Research Proposal also seeks to find outwhether exchange rates do have a random walk and attempts to explore its determinants in both theshort run and long run. In particular, it looks at the relationship between exchange rate volatility andmacroeconomic fundamentals as well as other factors such as rational expectations, economic
openness, consumer confidence, political events and asset market variables. Understanding the impactof the determinants of exchange rate would help to promote currency stability and greater certainty forinternational trade, which in turn, enable policy makers to pursue greater economic stability. Thisresearch will focus on three currencies: UK Pound, US Dollar and the Euro.
Key literature
Edison, H. J. (1987) Purchasing Power Parity in the Long Run: A Test of the Dollar/Pound ExchangeRate 1890-1978. Journal of Money, Credit and Banking, vol.19, no.3, August, pp.376-387
· This literature provides an in-depth explanation about the relationship between purchasing powerparity (PPP) and the movement of exchange rates in the long run. The economic theory of PPP isthat equilibrium exchange rate between two nations is determined by the ratio of domestic andforeign prices. The model was based on the data of the Dollar/Pound exchange rate from 1890-1978. By testing http://www.ttc-switch.com/thesis_sample/gongshangguanlizuoyexuqiu/the impact of PPP over this long period of time, it is possible to makeconclusions about the long run trend of the economy. The main findings of this literature supportthe theory that the relationship between exchange rates and relative price level would becomeclearer in the long run (with changes in structural factors taken into account)
· Together, these findings implied that PPP is one of the main determinants of exchange rate thatshould be included in the RHS of the regression model.
Chiang, T. C. (1985) The Impact of Unexpected Macro-Disturbance on Exchange Rate in MonetaryModel. Quarterly Review of Economics and Business, vol.25, no.2, Summer, pp.49-59
· This literature provides a closer look at the relationship between expectations and the behaviour
of exchange rates, which will help to fulfil the gaps of this research project. It is suggested that thekey determinants of the movements of exchange rates were: future expectation of exchange ratesand the basic determinants that consist of relative money supply, relative real incomes andrelative interest rates. Therefore, rational expectation plays an important role in determining thebehaviour of exchange rates.#p#分頁標題#e#
· On the other hand, this article is also relevant to my studies as it uses very similar theories aboutrational expectations. Thus it will also help me to have a deeper understanding for this topic.
· The findings of this literature support the theory that unexpected changes in relative moneysupply, real incomes and interest rates do make relatively significant effects on the movements of
exchange rate. Thus the division of expected and unexpected components on the RHS should bencluded in this project in order to make clearer the impact of macroeconomic variables.UB07006774 2
Rose, A. K. (1994) Are Exchange Rates Macroeconomic Phenomena. Economic Review – Federal
Reserve Bank of San Francisco, vol.1, pp.19
· This literature is relevant as it has a similar goal to this research project, which is to find out moreabout the determinants of the exchange rate’s volatility. Rose (1994) argued that macroeconomicvariables are relatively unimportant factors in explaining the behaviour of exchange rate. Hefound that exchange rate stability could be achieved without the cost of macroeconomicinstability. Thus, it helps to understand that there should be more variables in the RHS rather thanonly macroeconomic variables.
· Information about setting up regression model as well as independent variables is also available in
this article. It attempted to test the relationship of exchange rate volatility(LHS) with two types offundamentals (RHS): traditional and virtual fundamentals. Traditional fundamentals are derived
from macroeconomic variables such as nominal interest rate, money stock, real GDP andpurchasing power parity. Virtual fundamentals are derived from asset market variables. Inaddition, the model used double-log functional form, together with variables used in the literature;it suggested a model framework that this project might follow.
· Further information about the calculation of expected exchange rate was also provided: expectedexchange rate = α(i-i*)
· In 1998, Williams et al. carried out a very similar research with the same economic theory andmodel: Are exchange rates determined by macroeconomic factors? (Williams et al., 1998) Thisliterature again supports the finding that the existence of a link between exchange rates andmacroeconomic fundamentals is very weak. In addition, it raised a new question about whetherrisk premia were absent because of monetary policies in sample countries, which might also beincluded in this project.Blomberg, S. B. and Hess, G. D. (1997) Politics and Exchange Rate Forecasts. Journal of
nternational Economics, vol.43, pp.189-205
· This paper aimed to construct exchange rate models using political events and found that there
was indeed a significant relationship between exchange rate’s behaviour and political factors. It is
also found that exchange rates are correlated to political factors whether or not macroeconomic#p#分頁標題#e#
variables are included.
· This literature provided political factors that can be included in the RHS of the regression model
for this research project, i.e. approval ratings, rate of exchange rate growth for election, non
election period, and the exchange of the party in power.
Duarte, M. (2007) Exchange Rates and Business Cycles Across Countries. Economic Quarterly,
vol.93, no.1, Winter 2007, pp.57-76
· This is one of the latest literatures in this field. It also aimed to test the relationship between
nominal exchange rates volatile and business cycles. A number of useful variables were used in
the model including Real GDP, Consumption, Investment (gross fixed-capital formation),
Exports, Imports, Net Exports (net X = real (X-M) / real GDP) and Economy Structure.
· The findings of this literature support previous studies that there is no correlation between
nominal effective exchange rates and macroeconomic variables such as real GDP, Consumption
or Investment. However, it raised a question about whether the structure of the economy might
affect this relationship. It is found that the non-correlation between exchange rates and macrovariables
is inconsistence across countries in the sample, which are 36 countries in this case.
Although exchange rates fluctuate more in developing countries, Duarte et al. (2007) discovered
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that exchange rates tend to have more positive correlation with macro-variables in these countries
and the higher fluctuations of the exchange rates are related to larger fluctuation of real GDP,
consumption and investment. The reasons for the differences of the outcome across developed
and developing countries are suggested to be the differences in their economic structures and the
nature of the shocks that they faced.
· These findings together suggested that countries with different economic structure should be
treated differently in the regression model, for instance, by adding dummy variables for countries
with different stage of development.
Laganà, G. and Sgro, P. M. (2007) The Exchange Rate Disconnect Puzzle: A Resolution? Asia-
Pacific Journal of Accounting & Economics, no.14, pp.43-68
· This literature provides a very comprehensive review about a number of solutions that could be
used to resolve the weak short-run relationship between macroeconomic variables and the
movement of exchange rates. Laganà and Sgro (2007) mentioned that the poor result, when
testing the determinants of exchange rate, might be that political factors were omitted. According
to Blomberg and Hess (1997), using political economic models might help to explain the short run
behaviours of the exchange rates, with data collected from three Western countries: Germany,
USA and United Kingdom.
· Other models that should be considered when researching the movements of exchange rates are:#p#分頁標題#e#
non-linear exchange rates models, utility-based new open economy macroeconomic framework
and rational expectations with present value model. It is also mentioned that the use of assets
pricing models and microeconomic explanations might be used to resolve the weak relationships
of exchange rate and its theoretical determinants.
· Gathering all of the findings above will give a lot of help to complete the regression models in
terms of choice of functional forms, LHS variables and credibility.
Research question / hypothesis
The main question that this Proposal seeks to answer is:‘What are the determinants of exchange rate‘s
behaviour?’ This major question can be disaggregated into smaller and more focused questions:
· Are the relationships between exchange rates’ behaviour and changes in macroeconomic variables
such as real GDP, consumption, investment and international trade flowindeed significant in
either short run or long run?
· Is exchange rate’s short run random walk caused by currency speculation/risk premia or political
events ?
· Whether exchange rate’s long-term trend is related to purchasing power parity or rational
expectation ?
All of these questions are not new and they were all covered by previous literatures with different
approaches that will be consulted in this research project.
Methodology and data to be used
This project will use Ordinary Least Square regression model as the core framework for testing
hypothesis mentioned above. The LHS variable is spot exchange rate of Dollar/Pound and
Euro/Pound separately in two different models. To examine the volatility of exchange rate, the data of
percentages of change in spot exchange rate can be computed and included in the LHS as well. The
RHS variables will include macroeconomic variables (real GDP, consumption, investment); trade
flow (import, export and net export with foreign countries); purchasing power parity model; currency
UB07006774 4
speculation/risk premia and dummy variables for special political events and different economy
structures in terms of stage of development. However, these variables will be divided into two
different models with respect to short-term and long-term effects. The short-run model will use
original data of exchange rate; meanwhile the long-run model will use moving averages of exchange
rate to smooth out the short-term currency shocks and emphasis on the long-term trends. The problem
of non-linearity is noted and the use of double-log functional form will also be considered as an
alternative model in this research project.
Data of Dollar/Pound and Euro/Pound exchange rates can be collected from the website of the Bank
英國dissertation網of England. Data of UK macroeconomic variables, trade flow and stock market index can be collected#p#分頁標題#e#
from the Economic and Social Data Service (ESDS) and the International Financial Statistic (IFS).
Quarterly data are available from 1970-2008. Data on elections and changes in political party in
power are provided by Alesina and Roubini (1990)
Proposed chapter structure
Abstract
· Provide some general ideas about the research topic and a summary of the key findings
Introduction
· Present the reasons behind and the motivations of the research project, i.e. to provide higher
certainty for international trade and pursue greater economic stability.
· A summary of the key findings by previous literatures.
· Make clear which literature provides which variables that are considered as determinants of
exchange rate’s behaviours.
· The scope of the research, i.e. consider only 3 types of currencies: UK Pound, US Dollar and
Euro; having UK as the domestic economy from 1970-2008.
The underlying framework
· Explain the economic theory of the model, i.e. exchange rates are said to be determined by
macroeconomic fundamentals, purchasing power parity, …
· Explain how the variables are constructed, e.g. rational expectation is derived from relative
interest rate, how the dummy variables for political events is obtained, …
· Explain why the framework should be divided into short run and long run model
The short run model
· Outline economic theory of the short run model
· Identify key variables
· Construct model and explain the method
· Hypothesis testing and conclusions
The long run model
· Outline economic theory of the long run model
· Identify key variables
· Construct model and explain the method
· Hypothesis testing and conclusions
Summary and conclusion
References
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Bibliopraphy
Alesina, A. and Roubini, N. (1990) Political Cycles in OECD Economies. National Bureau of
Economic Research, Cambridge: NBER, working paper no. 3478, October
Blomberg, S. B. and Hess, G. D. (1997) Politics and Exchange Rate Forecasts. Journal of
International Economics, vol.43, pp.189-205
Chiang, T. C. (1985) The Impact of Unexpected Macro-Disturbance on Exchange Rate in Monetary
Model. Quarterly Review of Economics and Business, vol.25, no.2, Summer, pp.49-59
Devereux, M. B. (1997) Real Exchange Rates and Macroeconomics: Evidence and Theory. Canadian
Journal of Economics, no.4a, November, pp.773-808
Dornbusch, R. (1976) Expectations and Exchange Rate Dynamics. The Journal of Political Economy,
vol.84, no.6, December, pp.1161-1176
Duarte, M. (2007) Exchange Rates and Business Cycles Across Countries. Economic Quarterly,
vol.93, no.1, Winter 2007, pp.57-76
Edison, H. J. (1987) Purchasing Power Parity in the Long Run: A Test of the Dollar/Pound Exchange#p#分頁標題#e#
Rate 1890-1978. Journal of Money, Credit and Banking, vol.19, no.3, August, pp.376-387
Frankel, J. A. and Rose, A. K. (1994) A Survey of Empirical Research on Nominal Exchange Rates.
National Bureau of Economic Research,Cambridge: NBER,working paper no. 4865, September
Laganà, G. and Sgro, P. M. (2007) The Exchange Rate Disconnect Puzzle: A Resolution? Asia-
英國dissertation網Pacific Journal of Accounting & Economics, no.14, pp.43-68
Lee-Lee, C. and Hui-Boon, T. (2007) Macroeconomic Factors and Exchange Rate Volatility:
Evidence from Four Neighbouring ASEAN Economies. Studies in Economics and Finance, vol.24,
no.4, pp.266-285
Rose, A. K. (1994) Are Exchange Rates Macroeconomic Phenomena. Economic Review – Federal
Reserve Bank of San Francisco, vol.1, pp.19
http://www.ttc-switch.com/thesis_sample/gongshangguanlizuoyexuqiu/Russ, K. N. (2004) Exchange Rate Variability and Foreign Direct Investment. Ph.D. dissertation, The
Johns Hopkins University, United States -- Maryland. Retrieved April 28, 2009, from ABI/INFORM
Global database. (Publication No. AAT 3155674).
Williams, G. et al (1998) Are Exchange Rates Determined by Macroeconomic Factors? Applied
Economics, vol.30, pp.553-567