Link Between Exchange Rate Volatility And Economic Performance
Since the adoption of floating exchange rates in the developing countries in 1973,the question of whether exchange rate change have independent adverse effects on export and trade has attracted a lot of attention in the literature. The introduction of structural adjustment programmers by many of these countries and the attendant liberalization of exchange rates has brought the discussion of this issue further into global focus. Various studies carried out to estimate the relationship between trade and exchange rate uncertainty have mixed results. Kumar and Dhawan(1991), Cushman (1983), Pozo (1992), Kenen and Rodrik (1986), Peree and Steinherr (1989) found adverse impact on trade. Rogoff (1998) stated that exchange rate volatility creates significant problems for both exporters and importers (Arize 1996, 1998) reported negative significant long run and short relationship between exchange rate instability on imports and exports. Hooper and Kohlhagen (1978) found negative association between exchange rate instability and volume of trade but found positive association with export prices when exporters bear the exchange risk and negative impact when importers bear the risk.
Lanyi and Suss (1986) argued that exchange rate variability affects domestic currency and prices of exports and imports, which hinders the international transactions. It is often taken for granted that an increase in the risk leads risk averter individuals to shift towards least risky endeavour. This popular view has led many to conclude that exchange rate instability in principle should have negative impact on trade by increasing the risk of international trade activities (De Grauwe 1988). The risk averters worry about worst possible outcomes and increase exports to avoid the possibility of drastic decline in their revenues. However less risk averse or risk neutral persons are less concerned with extreme outcomes excessive real exchange rate variability has negative welfare effect, it reduce the level of international trade, affect investment decision and hampers economic growth(Edwards 1987).
The appreciation of currency because if the fluctuation results in large capital inflows adversely affects the trade (Baldwin and Krugman 1989). De Grauwe (1988) argued that association between exchange rate instability and trade should not be negative if the model is correctly specified and theoretically it should be positive. He further adds that negative impact if exchange rate instability is due to a mechanism, which he calls political economy of exchange rate instability.( Siddiqui and Salam 2000) showed that the reduction in misalignment reduces the adverse impact of exchange rate disequilibrium on economic growth. According to Rangrajan (1986) Volatility of exchange rate cab impair the smooth functioning of trade and world economy. It may also to lead higher prices for internationally traded goods as traders and banks add a risk premium to compensate unanticipated exchange rate fluctuations. Gognon (1993) and Bayoumi (1996) concluded that direct effects of exchange rate Volatility on trade volumes are very small. Gotur (1985) found that the relationship between trade and exchange rate uncertainty is insignificant and the results are nit robust but there could be an indirect impact on trade through trade prices if there is any. Bailey travels and Ulan (1986), Bacchante and Wincoop (1998) and Devereus and Engle (2002) found insignificant association between nominal exchange rate volatility and trade flows. Korey and Lastrapes (1989) found that the volatility tends to depress imports, but the association between exchange rate volatility and trade is insignificant. Exchange rate volatility increases the options to export in the world market. Higher volatility increases the potential gains from international trade, which makes production more profitable. A more volatile exchange rate implies higher risk exposure for international firms and this effect works in the opposite direction and trend to decrease production and volume of international trade. The net effect of exchange rate volatility in production and export depends on the degree of risk aversion of the form (Broll and Eckwert 1999).
International Literature Review:
Galbis (1975) has analysed the working of monetary, exchange and fiscal policies in a small open economy under fix and floating exchange rate system and with and without capital controls. A simple Keynesian type model was used to comprise all these cases. The case of perfect capital mobility under fix and floating exchange rates respectively shows that the interest rate equalization equation and the implied flow of international capital renders monetary policy ineffective in a small open economy with a fixed exchange rate. Floating of the foreign exchange rate provide the monetary authorities with leverage in determining the level of income. Monetary actions affect simultaneously the level of the exchange rate, the stock of money and the level of income. However fiscal policy is now rendered ineffective as a means of controlling income, it is only effect is felt on the exchange rate.
The conclusions derived from the floating rate model are negated because policy makers from a particular view about the appropriate level of exchange rate. Through direct monetary and fiscal policies to maintain target level of income and preserve the stability of the exchange rate. It is very difficult to maintain perfect short run stability of the exchange rate solely by means of monetary and fiscal policies. Capital controls affect the working of monetary, fiscal and exchange rate policies. Effective controls of either capital inflows of outflows in a fixed exchange rate system imply that monetary and fiscal policies will have income effect similar to those of a strictly closed economy, since capital controls eliminate the indignity of the monetary base that derives from capital improvements.
This conclusion with regard to the effectiveness of monetary and fiscal policies under capital controls in naturally reinforced if the exchange rate is floating. However the effects from the introduction of or changes in capital controls are different under fix and floating systems.
Itagaki (1981) provided a theory of the multinational firm under exchange rate uncertainty. His model takes into consideration taxation, transfer pricing, repatriation of profits intermediate inputs, intra firm trade, royalties, choice in currency denomination and hedging. H e concludes that the effects if uncertainty on production and trade volumes depends on whether exposure to exchange rate risk in positive or negative and those volumes may increase under uncertainty may well increase world trade and investment.
Kurz (1986) with expectation perspective studies the dynamics of foreign exchange rates in a Rational Belief Equilibrium (RBE). It shows that as in a Rational Expectations Equilibrium, exogenous shocks cause some fluctuations in the foreign exchange rate but this effect is very small and cannot explain the observed high quality of foreign exchange rate. The results of his analysis regarding the volatility of foreign exchange rates shows that the volatility if foreign exchange rates originates in the motive for optimal portfolio adjustment and this mostly reflects the movement if financial assets. This uncertainty is generated neither by the exogenous variables nor by monetary shocks in the economics. Trade in the world economy involves multiple commodities, many commodities which are imported by a country, are not exported by the same country and a large number of commodities are not traded internationally at all. Variations of the exchange rate must have a limited effect in the domestic price level even if all prices are completely flexible.
The study by Brada and Mendez (1988) included 15 Latin American countries in their study which covers the 1973 to 1977 period. Their conclusion suggested exchange rate uncertainly may inhibits bilateral exports, they do not use a measure of exchange rate volatility but instead rely on a various dummy variables to account for the effects of fixed versus flexible exchange rate regimes.
Baxter and Stockman (1989) investigated the time series behaviour for a number of macroeconomic aggregates under alternative exchange rate systems during the post war period. They use a sample of 49 countries and find little evidence of any differences in the behaviour or macroeconomic aggregates or trade flows under alternative exchange rate system. Given that the conclusion could be drawn that exchange rate volatility did not affect macroeconomic behaviour in the large cross section of countries considered.
Peichett (1991) contributed to the discussions of the empirical link between the real exchange rate economic performances by providing evidence for the three facts about the real exchange rate in 56 developing countries including Pakistan over the period 1966 to 1988. The author applied statically techniques of standard deviation inter quartile range Kurtosis and Skewness to analyses the data about the variables selected in this study, Real Exchange Rate GDP and Consumer Price Index. This paper firmly established one stylized fact and examined two practical implications of this fact. The recent historical process of exchange rate management in many LDCs had produced a distinctive pattern of changes in the RER. Changes tend to a skewed with large depreciations of the real exchange rate much likely than equal sized appreciations. He concluded with a discussion of the limitations of the current research and some speculations. The major limitations of this present is that only unconditional RER innovations were examined. A model of RER fundamentals along the lines of Edward 1999, or El Badawi 1991 would allow the decomposition of RER changes into parts due to change in fundamentals and conditional innovations. This also would allow the distinction between persistent misalignment with infrequent corrections and pure variability especially due to fundamentals as opposed to policy to be more clearly drawn (Edwards 1987). Given the apparent importance of misalignment demonstrated previously and the importance of the distribution of uncertainty evidence in this paper. This seemed like a promising lines of research. Also recent theoretical work by serve 1991 has suggested that anticipated devaluations may inhibit private investment, which makes the decomposition into conditional and unconditional innovations even more interesting.
Serven and Solimano 1992 investigated the economic adjustment and investment performance for 15 developing countries, using the pooled cross section time series data from 1975 to 1988. The investment equation estimated in the study used exchange rate and inflation as proxies for instability in each case, instability was measures by the coefficient of the variation of the relevant variables over three years. The two measures were found to be jointly significant in producing negative effect on investment.
Kroner and Lapstrapes (1994) used a multivariate GARCH-in mean model and find some evidence that nominal exchange rate volatility is related to international trade for five developed countries including the United States. The authors find evidence of a negative effect for only two countries in their sample, the United States and the United Kingdom. Using conventional statistics the author find evidence that the contemporaneous measure of exchange rate uncertainty impacts trade significantly at the 10 percent negative effect level for the United State and positive effect for the West Germany. For France and Japan the estimated effects are positive and insignificant although the author do find evidence that all volatility measures belong using a like hood ratio test.
Azienman (1994) developed a model where risk neutral producers can diversify internationally to increase the flexibility of production in response to shocks under conditions of free entry. He showed that a fix exchange rate regime is more conductive to FDI relative to a flexible exchange rate regime for both real and nominal shocks. Fixed exchange rates are better at insulting real wages and production from monetary shocks and are associated with higher expected profits. The higher expected income, in turn, supports higher domestic and foreign direct investment. In the case of productivity shocks, flexible exchange rates lead to lower volatility in employment and lower expected profits because the exchange rates move to moderate the shock. In this model flexible exchange rate limit the firm’s incentive to shift production to the most productive economy by absorbing productivity shocks.
Campa and Goldberg (1995) reported that the effect of the exchange rate on investment can change as patterns of external exposure shift over time. While U.S manufacturing sectors were primarily export exposed in the 1970,s they became predominantly import exposed by the early 1980,s. Consequently, exchange rate appreciations reduced investment in durable goods sectors in the 1970,s but stimulated investment after 1983. While exchange rate volatility depressed investment, the effects were small.
Rose (1996) examined a larger data set of twenty industrialized countries and considers the question of whether fixed exchange rate; bottle up; volatility which is released when the exchange rate is floated or devalued. The volatility of macroeconomic variables three years prior to and three years after floats and devaluations is examined for evidence if exchanges in volatility. It is found that exports and the current account become more variable after such episodes, though other macroeconomic aggregates do not. The conclusion is that there is little evidence of significant increase in volatility due to changes in the exchange rate regime.
Adubi et al. (1999) evaluated the impact of price volatility and exchange rate volatility on agricultural trade flow of Nigeria over the period 1970 to 1994. The authors developed Linear Regression model and Extended Vector Autoregressive (EVAR) model and ARIMA model for analysis of the variables selected in this study, Export, Output, Imports, Real Economic Activity i.e. GNP & Exchange Rate. Two policy implications arouse from this study:
The monetary authorities should adopt a mechanism that will lead to the stability of the exchange rate. Erratci changes in the exchange rate have a long term negative effect on production of agricultural exports.
The government should monitor the marketing system of agricultural exports to ensure that farmers are paid fully by the buying agents so that the full benefit of production increase resulting from liberalization can be reaped. Community exchange programmes should be explored as a plausible mechanism for assisting farmers and exporters to hedge against a rash of changes in the marketing system in both prices and exchange rates.
Bleany et al (1999) presented a model in which a developing country may reduce inflationary expectations by pegging its exchange rate to the currency of an advanced country or a basket of such currencies at the expenses of foregoing its ability to compensate for real exchange rate shocks. The authors developed this model and collected the data about 80 developed countries including Pakistan over the period 1980 to 1989. They applied regression analysis technique on the variables selected for analysis in this study i.e. Inflation, Output, Real Exchange Rate and Equilibrium Real Exchange Rate. Their empirical results based on data from 80 developing countries over the period 1980 to 1989 are generally consistent with the theoretical model. After allowing for effects such as differing variances of terms of trade shocks across countries. The chief prediction that there is a trade off in the choice of exchange rate regime between inflation reduction and the stability of output and inflation. It is supported by the data these results suggested that the widespread adoption of floating exchange rates in the developing world has had a significant cost, with inflation tending to be over 10 percent faster than in the typical pegged rate country. Their model provided a framework within which to interrupt this as a rational choice by countries which strongly prefer output stability to price stability.
Theory suggests a direct link between exchange rate volatility and economic performance but no consensus exist regarding the impact of exchange rate volatility on trade and economic performance because various studies have reported the mixed results. Chett (1991) investigated the empirical link between real exchange rate and economic performance. Adubi et al. (1991) evaluated the impact of price volatility and exchange rate volatility on agricultural trade flow. Bleany et al (1999) presented a model in which a developing country may reduce inflationary expectations by pegging its exchange rate to the currency of an advanced country. Frey (1999) investigated the impact of short run volatility of exchange rates on the volume of experts. Cooper (1999) compared the scope of different exchange rate choices availed by rich and developing countries. Liwang (2000) took a new empirical look at the effect of exchange rate volatility on international trade flows. Kawai et al. (2000) discussed conceptual and empirical issues relevant to exchange rate policies. Larrain et al. (2001) light on the question of which exchange rate arrangement middle income countries should adopt. Frydman et al (2001) argued that the standard Rational Expectation Hypothesis (REH) assumption is the primary reasons for the gross empirical failure of the monetary models of the exchange rate. Edwards (2001) analysed the relationship between exchange rate regimes, capital flows and currency crises in emerging economies.
Yeyati et al (2002) studies the relationship between exchange rate regimes and economic growth. Esquivel et al (2002) described the exchange rate volatility of G-3 countries. Rollemberg et al (2002) emphasized the relationship between alternative exchange rate regimes and the different concepts of money and the role of the market as an economic regulator.
Edwards et al (2002) analyzed the empirical effect of terms of trade on economic performance under alternative exchange rate regime. Zhang (2002) reviewed China’s foreign exchange reforms and analyzed their impact on the balance of trade and inflation. Maskey (2003) reviewed the patterns of economic shocks affecting the SAARC member countries. Harberger (2003) investigated the influence of economic growth on real exchange rate. Vuletin (2003) analysed the influence of exchange rate regimes on fiscal performance focusing on the difference between fixed & floating exchange rate. Shambaugh (2003) investigated how a fixed exchange rate affects monetary policy. Avellan (2003) evaluated the relationship between parallel exchange rates. Hoffman (2003) compared fixed exchange rate with floating exchange rate. Clark et al. (2004) reviewed the impact of exchange rate volatility on the world trade. Lourenco (2004) analysed the global picture of exchange rate regimes of 33 advanced and emerging economics Hussain et al.(2004) investigated the durability and performance of alternative exchange rate regimes of all IMF member countries. Coudert et al (2005) analysed the impact of exchange rate regimes on inflation and growth on ten Asian countries. Asia et al (2005) improved the existing literature on exits from fixed exchange rate regimes. Augir et al (2005) evaluated the growth effects of real exchange rate misalignment and their volatility. Egert et al. (2005) analysed the direct and indirect impact of exchange rate volatility via changes in exchange rate regimes on the export performance. Tenreyro (2006) addressed the issue of how exchange rate variability affects trade. Nabi (1996) reviewed the recent trade performance and progress regarding tariff reform of Pakistan. Agha et al. (2005) investigated the channels through which monetary policy shocks are propagated in Pakistan Din (2005) examined the trade liberalization among South Asian countries. Aurangzaib et al (2005) analysed the impact of exchange rate volatility on growth and economic performance of Pakistan. Kamal (2006) studied whether exchange rate instability effects trade in Pakistan or not if so, then in what direction.
After having studied some of the international and national studies regarding impact of exchange rate volatility on macro economic performance of Pakistan. It is realised that volatility in exchange rate of Pakistan can influence long term decision by affecting the volume of exports and imports, the allocation of investment and government sales and procurement policies. In medium term, it can affect the balance of payments and the level of economic activity while in the short term local consumers and the local traders can be affected. So the monetary authorities of Pakistan should adopt a mechanism that will lead to the stability of the exchange rate, because erratic changes in the exchange rate have a long term negative effect on the macro economic performance of Pakistan.
Need help with your literature review?
Our qualified researchers are here to help. Click on the button below to find out more:
In addition to the example literature review above we also have a range of free study materials to help you with your own dissertation: