When e increases the foreign country becomes relatively more expensive and we say that the real exchange rate depreciated. The purpose of this paper is to highlight the main determinants of the exchange rate from a monetary perspective. Macroeconomic determinants of real exchange rates nber. In this dynamic model of the real exchange rate both real and nominal determinants of real exchange rate misalignment are studied, with emphasis on macroeconomic policy and nominal devaluation, along with other explanatory variables suggested by the theory. Pdf the determinants of the real exchange rate in zambia. Here real exchange rate is calculated as nominal exchange rate cpi cpi where cpi is the foreign price and cpi is the domestic. The real exchange rate is explained by the expected future real exchange rate, the real interest rate differential and the risk premium. A case study of pakistan mahnaz muhammad ali 1, salma shaheen 2 nosheenshahzadi 3 abstract. We also hypothesize a third factor which may affect real exchange rates shocks to the global financial system, which we proxy by the real price of gold. Having obtained the volatility of exchange rate through the garch 1,1 techniques, the ecm was used to examine the various determinants of exchange rate volatility in nigeria, while the cointegration analysis reveals. P in words, the real exchange rate is the relative price of a foreign basket of goods in terms of comparable domestic baskets of goods. Section 4 analyses the cointegration approach and section 5 tests for the longrun properties of the real exchange rate movements. Determinants of the real exchange rate in a small open. Nominal and real exchange rates of an open economy with formula.
Theories of exchange rates foreign exchange financial. Under the assumption of rational expectations, the model yields an expres. In order to manage foreign exchange rate efficiently, macroeconomic factors of foreign exchange rate should be deeply investigated. The determinants of exchange rate volatility in south africa. The purpose of this paper is to explain the magnitude of the misalignment of the real exchange rate and its determinants for the mena countries. Determinants of the swiss franc real exchange rate tommaso mancini griffoli, christoph meyer, jeanmarc natal and attilio zanetti snb working papers. Differences in gdp per capita relative to trading partners is an important component of short term exchange rate adjustment mechanism. Box 882, politickych veznu 7, 111 21 praha 1, czech republic. Highlights we developed a real exchange rate model for a smallopen economy.
The model was tested on canadian data for the period 19722010. In a fixed exchange rate regime, the rates are decided by its government. He claims that trade integration andrealexchange rate volatility are structurally linked and there is a negative correlation between them. According to relative ppp, price changes due to differences in inflation are the cause and exchange rate changes are the. This research is concerning on the determinants of foreign exchange rate in malaysia, in other.
None of the domestic fiscal variables has any statistically significant impact on the growth of the real exchange rate over the shortrun. For example, under the purchasing power parity ppp approach, the longrun real exchange rate is assumed to be stationary so that any deviation from this rate reflects misalignment. Exchange rates play a vital role in a countrys level of trade, which is critical to almost every free market economy in the world. The result further indicates that there is evidence of long run relationship between real exchange rate and two explanatory variables gross domestic product growth rate and trade openness. Let us make an indepth study of the nominal and real exchange rates. The present research tests validity of this hypothesis in association with the exchange rate between the indian rupee and the us dollar. The three factors are sectoral total factor productivity differentials, real interest rate differentials, and the real price of gold, representing real. Thus, the determinants of the real exchange rate are the shocks that drive it from the equilibrium. The naira exchange rate depreciation and volatility is among the vast macroeconomic maladjustments which have unfolded in the nigerian economy in the recent past. This paper presents a model that integrates money, relative prices, and the current account balance as factors explaining movements in nominal effective exchange rates.
Similarly, an american can exchange two dollars to get one pound. Macroeconomic determinants of real exchange rates william h. Exchange rates play a vital role in a countrys level of trade, which is critical to most every free market economy in the world. When e increases the foreign country becomes relatively more expensive and.
This study note is intended to provide an overview of what interest rates represent, how they. This paper investigates the determinants of real exchange rate volatility in nigeria from 1981 through 2008. Consequently, exchange rates are among the most watched, analyzed, and manipulated economic measures. Determinants of the exchange rate in the short run in the short run, movements of currency respond to short run differences in interest rates so that short run rates of return are equalized across borders. Misalignment is defined as the deviation of the real exchange rate from its equilibrium level, unlike volatility which is defined as fluctuations that are very frequent but do not persist.
The result further indicates that there is evidence of long run relationship between real exchange rate and two explanatory variables gross. International trade and investment, international finance and macroeconomics this paper presents a model that integrates money, relative prices, and the current account balance as factors explaining movements in nominal effective exchange rates. During periods of excessive fluctuations in exchange rates, foreign trade and investments could be. In most countries, there was a shift between the preglobal crisis period, when the region saw significant real appreciation of currencies, and. Determinants of the equilibrium real exchange rate also include factors that affect the net trading position of the home country in world markets, as well as the underlying propensity of the home country to be a net lender or borrower of capital. Pdf on jan 15, 2017, kalimullah bhat and others published determinants of real exchange rate movements in south asian countries.
The real exchange rate as defined by pilbeam 2006 is the nominal exchange rate. When the exchange rate is officially fixed, essentially the same monetary influences that determine the exchange rate affect the level of official settlements corresponding to the balance of payments surplus or deficit. An empirical model linking the real exchange rate to its theoretical determinants is then specified. The large and persistent deviations of nominal exchange rates from their purchasing.
The determinants of the real exchange rate in zambia. Here we focus on the determination of the real exchange rate, while recognizing that monetary factors are important. Now suppose the price index is a geometric average of traded and nontradedgood prices. Amuedodorantes and pozo 2004 also find that remittances inflows lead to an appreciation of the real exchange rate. The findings are generally consistent with the predictions of the. The real interest rate differential enters with a negative sign indicating that an increase in the differential will cause an appreciation of the real exchange rate. Working paper on the causes and effects of exchange rate volatility on economic growth. Following literature, we identified the potential determinants of real exchange rate as lag of real exchange rate, real interest rate, inflation rate, trade openness and.
Timevarying transitional dynamics chunming yuan department of economics, university of maryland, baltimore county hilltop circle, baltimore, md 21250, usa abstract in this paper, i consider modeling the effects of the macroeconomic determinants on. An ardl approach 37 in this study, an extension of the benchmark model is used where the equilibrium real exchange rate is a path upon which an economy maintains both internal and external balances. Now that we have discussed the importance of forex rates, let us move on to major determinants of exchange rates in a floating exchange rate regime. The apparent shift in exchange rate policy to boost export performance and promotes surplus. I developed a monetary model of the real exchange rate in this paper and showed that longrun determinants of the real exchange rate are a function of the real money supply, domestic and foreign interest rate, real gdp, real government expenditure, deficit per gdp, domestic and foreign outstanding debt per gdp, domestic and foreign externally. Now suppose the price index is a geometric average of traded and. Determinants of venezuelas equilibrium real exchange rate. Determinants of real exchange rate in papua new guinea boniface aipi. Exchange rate is an important macroeconomic policy instrument which effects all macroeconomics variables.
The determinants of the real exchange rate in zambia aerc. Jul 22, 2008 the present research tests validity of this hypothesis in association with the exchange rate between the indian rupee and the us dollar. Determinants of turkish real effective exchange rates. Pdf determinants of real exchange rate movements in south. Exchange rate overshooting shortrun response to a change in market fundamentals greater than longrun response helps explain sharp movements tendency of elasticities to be smaller in the short run than in the long run figure 12. The equilibrium real exchange rate depends not only on productivities but also on some other. So exchange rate volatility and its determinants for countries have become a new focus of interest. Real interest rate is used to assess exchange rate movements as it includes interest and inflation rates, both of which affect exchange rates.
The determinants of the real exchange rate with diagram. The findings are generally consistent with the predictions of the model. This study analyses the main determinants of the real exchange rate and the dynamic adjustment of the real exchange rate following shocks to those determinants using yearly ethiopian time series. The rate of depreciation is equal to the inflation differential. The determinants of real exchange rates in transition.
Major determinants of foreign exchange rates governmentadda. Gdp per capita, oil prices, fiscal expenditures, and openness are fundamemntal determinants of turkish real exchange rates. Hopper r eaders of the financial press are familiar with the gyrations of the currency market. Determinants of venezuelas equilibrium real exchange rate by. Real exchange rates in the transition region have been relatively volatile over the past two decades, with major variation across countries and over time.
Determinants of venezuelas equilibrium real exchange rate for venezuelas reer, three factors are likely to be important. We discuss the implications of the long and short run determinants of exchange rate volatility and the volatility growthnexus. Real exchange rate volatility is an important contributor to risks in the financial world. The natrex approach offers an alternative paradigm to the purchasing power parity for equilibrium real exchange rates.
Nominal and real exchange rates of an open economy with. Determinants of equilibrium real exchange rate and its. Fundamental determinants of exchange rates oxford scholarship. Therefore, the relative version of ppp states that there is a link between the expected exchange rate es n and expected inflation rates i in two countries. The determinants of the real exchange rate associate reading. The various determinants of exchange rates uk essays. The main determinants of the exchange rate sciencedirect.
The real exchange rate rer refers to the relative price of goods of britain and usa. This research is concerning on the determinants of foreign exchange rate. Hyder and mahboob 2005, saadisedik and petri 2006 find similar results for pakistan and jordan. Determinants of real exchange rate in papua new guinea. In particular, an attempt is made to investigate the impact of bank rate policy of the reserve bank of india rbi and interest yield differentials between the india and the us securities. Pdf determinants of real exchange rate movements in. Natrex is the acronym for natural real exchange, referring to a medium. Investment i depends on both the domestic and the world rate of interest. The working paper series is intended to provide the results of research undertaken within the bank to its staff, interested institutions and the general public. Aside from factors such as interest rates and inflation, the exchange rate is one of the most important determinants of a countrys relative level of economic health. Macro determinants of the real exchange rate in a small open.
Thus money and the current account are the proximate determinants of changes in real effective rates. In surveying theoretical models of exchange rate determination, therefore, it is appropriate to examine the empirical regularities that have been characteris. It was found that the model performs very well in both long and short runs. Oil prices and other commodity prices are a primary source of fluctuation in the equilibrium real exchange rate. The study examined the main determinants of real exchange rates fluctuations in ghana using the autoregressive distributed lag ardl approach bound testing approach. Given all other parameters constant, there is a high corelation between differentials in real interest rate and the exchange rate of a currency.
To set the optimal real exchange rate, the directions and strength of these determinants should be known. The determinants of exchange rate volatility in south africa trust mpofu ersa working paper 604 may 2016. Although each factor in isolation has limited explanatory power, we find that these three factors in conjunction can successfully explain the medium to long run movements in 14 bilateral u. No matter which way currencies zig or zag, it seems there is always an analyst with a quotable, ready explanation.
The basic model is first analyzed under static expectations. All factors that determine foreign exchange supply and demand cause indirect exchange rate volatility to change. Importers, exporters, investors and the monetary authorities are all concerned with the behavior of the exchange rate, as it directly or indirectly affects them. The change in interest rate, the growth of money supply, the commodity price and the us debt per gdp have a negative impact on the growth of the real exchange rate over the short run. The study examines the determinants of real exchange rate in the recent years in nigeria over the period of 1970 to 2006 using the nigerian time series data. Pdf determinants of the real exchange rate in a small open. This paper therefore, investigates the determinants of real exchange rate volatility in nigeria from 1981 through 2008.
The determinants of real exchange rate crawford school of public. There are many factors that affect the real exchange rate volatility, even if the effect of each depends on the economic conditions of. Real exchange rates in the transition region have been relatively volatile over the. Foreign exchange rates, in fact, are one of the most important determinants of a countrys relative level of economic health, ranking just after interest rates and inflation. Currency weights in zambias real exchange rate 19901996. Let us make an indepth study of the determinants of the real exchange rate.
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