Transcript relationship of exchange rate with macro economic variables

BY: MUSHTAQ UR REHMAN
MOHAMMAD ALI JINNAH UNIVERSITY ,
ISLAMABAD CAMPUS
&
SHAFIQ UR REHMAN
SCHOOL OF MANAGEMENT
UNIVERSITY OF LIVERPOOL,UK
Introduction
Literature
Review
Theoretical Frame Work
Methodology
Results and Discussions
Conclusion
References
Introduction
How much of one currency is
worth in terms of another.
History
(Barter system, Paper
currency, Plastic money).
 The
Breton Woods Agreement in 1944
introduced an exchange rate system that
remained in effect till 1971.
 Exchange
rate in Pakistan
 The
foreign exchange market is one of
the largest markets in the world. By some
estimates, about 3.2 trillion USD worth of
currency changes hands every day.
A
growing body of literature has recently
focused on Exchange rate. It is now
widely recognized that Exchange rate are
important to economic development
 Branson
(1981) reported that real exchange
rates are influenced by real disturbances in the
current account and the time series seems to
give signal for adjustment.
 Simon
(1997) found that exchange rate and
current account have direct and positive
relationship with inflation and both exchange
rate and current account are the key factors
that badly affect the small economies.
 Kendal
(2004) found a substantial relationship
between exchange rates fluctuation and
current account balance.
 Jakab
and Kovacs (1999) reported that nominal
exchange regimes do not play important role in
tradable real exchange rate fluctuation. They
argued that policy of exchange rate was not the
main factor of real exchange fluctuations.
Instead supply shocks were the main
determinants of exchange rate fluctuation.


Dong (2006) on the other hand reported the influence
of macro economic variables on exchange rate. They
reported that monitory policy shocks, interest rates and
output gap significantly explained the variance of
exchange rate.
Binder (2000) opined that exchange rate forecasting is
linked with key macro economic variables such as
money, income, prices and interest rate
 Rehman
(2008) further concluded that inflation
were the strong macro economic variable that
cause appreciation and depreciation in
exchange of home currency, therefore inflation
is the key indicator for exchange rate.
Interest
Rate (X1)
GDP
(X4)
Exchange
rate (Y)
Current
account
(X3)
Inflation
(X2)
 Data
 Y=
Annually from 1990 to 2002.
a + bXi + Ei
a
= (∑Xί2∑Y) - (∑X∑XίY)
n (∑x2) - (∑x)2
b
= n (∑XίY) (∑X∑Y)
n (∑Xί) 2-(∑Xί)2
 Whenever
the interest rate rises return
on investment increases to investors both
for private and public investors. When
interest rate raises the country currency
appreciates .The main reason behind this
appreciation is that more and more
people come inside the county and
invest more and more. R=64.1%
 R2=41%
 When
the inflation rate of a country
increases the currency depreciate.
Because inflation is inversely related to
that of the value of currency.
 Analysis the regression relation between
the exchange rate fluctuation and the
inflation is 65.4%.this relationships very
high. It means the inflation is very
important to influence the exchange rate
fluctuation.
The
coefficient
of
determination i.e., R2 is 42.8% that
means that 42.8% of exchange rate
fluctuations is caused by changes in
 When
there is a surplus balance in the
current account the home currency
appreciates while in case of the deficit in
the current account the home currency
depreciates.
 Findings of the research is as under;
R=45.5%. it means the relationship
between current account and exchange
rate fluctuation is not very high.
Coefficient of determination is 11.9% i.e.
only 11.9% percent of the exchange rate
fluctuation is caused by the changes in
the current account.
Normal P-P Plot of Regression Standardized Residual
Dependent Variable: exhangerate
1.0
Expected Cum Prob
0.8
0.6
0.4
0.2
0.0
0.0
0.2
0.4
0.6
0.8
Observed Cum Prob
1.0
 When
the gross domestic product increases it
decrease the home currency depreciation. So
the gross domestic product is influencing the
exchange rate fluctuation.
 Findings of the research are as under; R=84.4%,
it means that there are strong relationship
between the exchange rate fluctuation and the
gross domestic product (GDP). The coefficient
of determination i.e. R2 is 71.1%. It means that
71.1% changes in exchange rate fluctuation is
caused by the changes in the gross domestic
product.
Normal P-P Plot of Regression Standardized Residual
Dependent Variable: exhangerate
1.0
Expected Cum Prob
0.8
0.6
0.4
0.2
0.0
0.0
0.2
0.4
0.6
0.8
Observed Cum Prob
1.0
 The
research findings are summarized below;
interest rates, inflation rate, current account,
real interest rate and gross domestic products
have important role in the exchange rate
fluctuations. The results in the Pakistan
economy context are as under; among all these
variables the most important is the gross
domestic products which have correlation
coefficient of R= 84.4% and with 71.1% of
coefficient of determination
 Inflation
rate is more influencing the exchange
rate fluctuation. The coefficient of correlation R
is Regression coefficient 64.1% i-e. R2 is 42.8%
while the coefficient of determination. Next the
relationship between interest rate and the
exchange rate fluctuation is R= 64.1% while the
coefficient of determination i.e. R2 is 41.1%.

Effects of current account on exchange rate fluctuations
is very low as compared to the above four determinants
of exchange rate. The coefficient of correlation is i.e R
=34.5% and the coefficient of determination i.e R2 =
11.9%. it means that exchange rate fluctuations is
caused only by 11.9 % by changes in current account
while the rest of the changes that is 99.1% changes are
caused by some other factor. Thus the effects of GDP
over exchange rate fluctuation are high, and the effects
of current account are very low.
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