This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.
This chapter will present literature review of previous researches which examine the relationship between exchange rate and four macroeconomic variables namely foreign direct investment, inflation rate, interest rate and trade balance. A proposed theoretical framework will be developed after the reviewing of relevant theories.
2.1 Review of Literature
2.1.1 Dependent Variable - Exchange rate
Exchange rate is important because it allows for the country to convert their currency into another, thereby facilitating international trade by doing transaction of purchase goods and services and even transfer funds between countries. Countries will export their comparative advantages product and import those is comparative disadvantages products for other countries. It also allows price comparison of similar goods in different countries. Basically, consumers will determine which of the goods to be consume and where they shipped or sourced by the differences of price. Thus, the exchange rate is a significant factor to influence the profitability of Multinational Corporation and the competitiveness of agricultural commodities. Those factors such as government policies, interest rates, inflation, market forces of supply and demand for a particular currency and a country balance of payment which are the factors interact to determine the exchange rate level.
According to Humpage (2003), government policies and market forces of supply and demand are the main two factors which influenced the exchange rates. Each of the country government can influence their currency through directly or indirectly intervention. Country government can control directly the value of their currency by setting a fixed exchange rate and maintain at the same value until such time as a government sees fit to change it. In other ways, government influences the value of country currency indirectly by changing interest rates or purchasing other currencies on foreign exchange market due to influence the supply and demand of money situation. An increase in the demand for a country's currency on the foreign exchange market usually will increase the value of its currency. If the demand the Malaysia export increased, it may caused to our Ringgit Malaysia to appreciate due to other countries would be demanding more Ringgit Malaysia in order to pay for the products and services. In the other hand, if the demand of our Malaysia import increased, it may caused to our Ringgit Malaysia to depreciate due to our country need to demand other countries currency in order paid for the products and services.
As mentioned in the chapter 1, Auboin and Ruta (2011) found that a change in the exchange rate can temporary affect the demand or supply of commodities and the competitiveness of Malaysia agriculture in the short run. Bourdon and Korinek (2011) measure that when the value of Ringgit Malaysia appreciates; it may causes to importers to pay more for the Ringgit Malaysia to buy our domestic products. While a stronger Ringgit Malaysia increase prices for importing countries, it may decrease the demand for Malaysia domestic prices and seriously affect the profitability of domestic companies. However, when the Ringgit Malaysia is strong, Malaysia multinational corporations and consumer can gain more enjoyment from the purchasing of foreign goods and services with a cheaper exchange rate. While a strong value of currency will makes to the imported goods become cheaper and it may also caused to our domestic products to become less competitive and could negatively influence a company's profitability. On the other hand, when the value of Ringgit Malaysia depreciate, foreigners could pay less for the Ringgit Malaysia and our domestic consumers and corporations need to pay more to exchanged for a unit of foreign currency. A weak Ringgit Malaysia may cause the demand for domestic products and services to increase. An increase in our domestic sales could causes to domestic price and profits to increase. However, a weakened Ringgit Malaysia caused to domestic importers has to pay more for a unit of foreign currency. Through the weakened on Ringgit Malaysia caused to our domestic products become more competitive compare than other country with a high value of currency, it could also positively influence domestic company's profitability.
Duasa (2007) examines the short and long run relationships between real exchange rates, trade balance, money supply and income in the case of Malaysia. In their research, they included the money and income variables in the study are purposely to absorption approaches to the balance of payments beside the conventional approach of elasticity by using exchange rates. Hence, they use the Error Correction Models (ECM) to determine and Autoregressive Distributed Lag (ARDL) approach to co integration whether there is evidence of relationship between trade balance and exchange rate in the long and short run in regard of Malaysian data, under elasticity approach. Liew et.al (2003) who studies the ASEAN 5 Countries and Japan for the sample period from 1986 to 1999, they found that the trade balance in these countries is affected by real money rather than nominal exchange rate and therefore they conclude the role of exchange rate changes in the trade balances has been exaggerated. Rahman et al., (1997) found a weak statistical evidence connecting exchange rate changes and the trade balance, as they employs cointegration and error correction models to examine the dynamics of the Yen-dollar real exchange rate and the US-Japan real trade balance. However the result of ADF test shows fail to affirm any long-run association between the Yen-Dollar real exchange rate and the US-Japan real trade balance.
2.1.2 First Independent Variable - Foreign Direct Investment
Foreign capital inflows known as investment inflows it comprises into three items which equity investment in Malaysia is hold by non-residents, loans obtained from non-residents and purchase of real estate in Malaysia by non-residents but excludes retained earnings (Sidek, Yusoff, & Munir 2009).
Kiat (2008) examine the relationship between FDI and exchange on ten developed country and he conclude that the exchange rate from seven developed country can positively affect FDI.
Pham and Nguyen (2010) investigate the impact of exchange rate on the Vietnam trade. They make an assumption that a depreciation of bilateral real exchange rate will reduces the cost of domestic labor or productive inputs that relative to foreign production costs. Once depreciation started it may helps the economic growing step by step, such as the manufacturing industry got an injection foreign capital or create a new opportunity to collaborate and create working opportunity to local residence. Thus the result shown a positive relationship on the bilateral real exchange rate in the FDI regression, and then it match to the finding stated. Hence, increase in real exchange rate represent a real depreciation of the home currency and then attract the FDI inflow to Vietnam. On the other side, Vietnam currency depreciation indirectly raises the wealth of foreign investors, because the cost of production low and it can export to foreign country to earn profit (Pham & Nguyen 2010).
Hence, there is a strong evidence of positive in long run relationship between Malaysia capital outflow and the key is foreign market size, international reserves and the real effective exchange which is base on ringgit side of exchange rate. Therefore, an appreciation of home exchange rate is postulated to have a positive impact on outward foreign direct investment (OFDI) because the foreign currency is depreciation, so it worth to hold a foreign asset. On the other hand, firms from countries with strong currencies have a higher desire to invest abroad due to lower start-up costs compare to higher start-up costs in home country. (Soo & Koi 2010; Ngie & Marial 2009).
However, there are some researchers argue that there is negative relationship between the FDI and exchange rate. Nazima (2011) investigate the relationship between exchange rate volatility and foreign direct investment in Pakistan. The major findings in his study conclude that exchange rate volatility has negative impact on FDI inflow in short run. Furthermore, a topic that relevant capital outflow or inflow, Hence there are a study regarding Malaysia's Outward FDI, and then the finding in this study is short run is negative relationship. (Soo & Koi 2010).
After that, the relationship between FDI and exchange rate it may negatively, for an example the exchange rate depreciation causes FDI to decrease. Furthermore, it may increase exports and provide gains, however foreign investors may lose as well due to they incur costs to prevent transaction and translation losses when currencies depreciate. Furthermore, there are research paper is determine exchange rate volatility and foreign direct investment in Nigeria, their finding result is the effects of both exchange rate volatility on FDI in Nigeria is negative. And the statistically shown significant negative coefficient of the exchange rate volatility is not surprising. This is because exchange rate is as a price and therefore its movements affect resource allocation in the economy.(Udoh & Egwaikhide 2008). In addition, there are a similar topic also had same result. There are the real exchange had a negative in both of the estimation presumably due to translation and transaction costs which discourage FDI or change in exchange rate volatility tends to reduce FDI activity, because negative correlation, it could improved competitiveness in other emerging countries and raises FDI to Foreign country through a diversification effect. (Dhakal, Nag, Pradhan, Upadhyaya 2010 & Quere, Fontagne, Revil 2001).
Furthermore, there is a research paper was concerned about Pakistan but it was about economic determinant for foreign direct investment. They finding is the coefficient of exchange rate is negative as expected, and then the depreciation of the country's currency would encourage the inflow of FDI. It also confirms the hypothesis that foreign investors are much interested in high returns on their investment. It is due to the rate of return and it attracted foreign investor who looking large profit for long run, and then if an appreciation of the currency could leads to increased firm wealth and provides the firm with greater low-cost funds to invest relative to the counterpart firms in the foreign country that experience the devaluation of their currency (Khan & Nawaz 2010).
2.1.3 Second Independent variable: Inflation
Inflation is a very important impact on changes in exchange rate because it signals to increasing price levels and falling purchasing power. The Purchasing power parity theory states that when domestic inflation is higher than foreign inflation, country's currency will depreciated and appreciate when domestic inflation is lower than foreign inflation.
There are several studies concerning the impact of inflation on foreign exchange market has been constructed and majority of the studies conclude that the foreign exchange rate is affected significantly by inflation (Achsani, Fauzi and Abdullah, 2010; Utami and Inanga,2009; Ndungu, 1997). Inflation happen when the general level of prices of goods and services across the economy rise over a period of time and eventually causing each unit of currency buys fewer goods and services when the money is losing its value.
According to Ndungu (1997), inflation in Kenya has risen tremendously and at the same time the exchange rate has depreciated sharply since early 1980s. The rising inflation was accompanied by the changes in the exchange rate, and he states that exchange rate would adjust itself to inflation rate differentials between Kenya and its major trading partners. On further analysis, he found there is bidirectional relationship existing between rate of inflation and exchange rate. Besides, Mungule (2004) shows the results on the existence of co integration between the nominal exchange rate and the domestic and foreign prices by using Johansen approach.
On the other hand, Sosunov and Zamulin(2006) has done a research project on the inflationary consequences of real exchange rate targeting by comparing between Accumulation of reserves between Russian and Chinese. They found out that People's Bank of China has managed to make its currency lower by avoiding the high inflation. In addition, Rose (2007) shows that for inflation targeting countries, the nominal and real exchange rate volatility is typically lower compare with the countries without inflation targeting by using the OLS Regression.
Meanwhile, Hwang (2001) employed Johansen's multivariate cointegration in order to examine the relationship between exchange rate of U.S dollar/Canadian dollar and inflation rate from January of 1980 to December 1996. The empirical result shows that there is a long run relationship between the exchange rate and inflation.
Besides that, Rawlins (2008) also measure the relationship between exchange rate and inflation by using quarterly data for a group of eleven Caribbean and Central American countries to conduct an empirical examination of the Purchasing Power Parity. By employing the Johanssen Cointegration technique, result shows that there is a strong existence of a stable long term relationship between exchange rate and inflation for each country and four of the major industrial nations.
On the other way, Maswana (2006) have conducted the studies about the short run and long run relationship between exchange rate and inflation in the Congo by using the Granger noncausality test to examine the interaction. The result shows that the Granger causality between exchange rate and inflation is bidirectional in the short run. In the long run, the exchange rate causes inflation without a feedback effect. Moreover, the result of short run bidirectional causality presents a serious threat to macroeconomic stability because of contributes of long term depreciation-inflation cycle as well as inertial inflation.
2.1.4 Third Independent Variables - Interest Rates
In the past decades, many of researchers have started to conduct their researches on the link between exchange rates and interest rates in both developed and developing countries. The researchers investigate the relationship between these two variables as they play an important role in the real and nominal sides of the economy which including the behavior of real output, domestic inflation, exports and imports. (Sanchez, 2005)
A number of studies have been proved that there are significant relationship exist between the exchange rates and interest rates by applied different theories in their study. The early research was conducted by Frankel (1979) which developed the asset-approach exchange rate determination model which combines the Chicago theory and Keynesian assumption in his paper. Chicago theory known as flexible-price monetary models which assume changes in the nominal interest rate reflect changes in the expected inflation rate. On contrast, Keynesian assumption also calls as sticky-price assumption which indicated that changes in the nominal interest rate reflect changes in the tightness of monetary policy. The result shows the positive relationship between the interest rate differential and exchange rate in the Chicago theory and negative relationship for Keynesian assumption.
Kanas (2005) using a multivariate regime switching framework to examine the relationship between the real interest differential and real exchange rate for US and UK on the period 1921-2002. His finding shows that the relationship holds in terms of regime dependence between the real interest differential and real exchange rates which explain that high (low) volatility regime for the real exchange rate of US/UK is dependent upon the fact that the real interest differential is in the high (low) volatility regime. Besides that, his findings dispute a regime link was established between the two variables as the nominal exchange rate regime switching perform an effect on the regime of the US/UK real exchange rate and the real interest differential.
Meredith and Chinn (1998) attempt to reject the propositions by the researchers about the uncovered interest parity (UIP) is the useless predictor of future exchange rate movements. Compare to previous researches which use short-horizon data, they used the interest rates on longer-maturity bonds for the G-7 countries in order to test whether the assumption of UIP still valid in today world. The result of the study shows the existence of perverse relationship between the interest rates and exchange rates within the G-7 countries and they conclude that UIP is a useless predictor of short-term movements in exchange rates but not for the longer horizons.
On the other hand, Yu Hsing (2007) applies the uncovered interest-rate parity theory in his paper and using the open macroeconomic model to analyze the exchange rate fluctuations for Egypt. The empirical results show the uncovered interest-rate parity theory is hold in his study and the nominal exchange rate in Egypt is negatively associated by the foreign interest rate. In other word, a higher foreign interest rate will reduce the demand for the Egyptian Pound and would cause the Egyptian Pound to depreciate because of the capital outflows.
Meanwhile, Utami and Inanga (2009) conduct the research by applied the International Fisher Effect to examine and analyses the effect of interest rate differential on the movement of exchange rate in Indonesia. They use quarterly and yearly data for the interest rates and changes in exchange rates in 2003-2008. Besides that, they chose USA, Japan, Singapore and UK as their foreign countries and Indonesia as the domestic country. The empirical result show that interest rate differentials have positive influence on changes in exchange rate for the USA, Singapore and the UK relative to Indonesian; however, the influence are not significant. In contrast, they found existence of significant negative relationship between the interest rate differentials and changes in exchange rates for Japan.
Diamandis, Georgoutsos and Kouretas (1996) examine the relationship between the real exchange rate and the interest rate from 1970-1994 by using the Johansen's multivariate co integration techniques. The empirical result of the co integration shows that the interest rate and U.S exchange rate was an existence of a long run relationship even if the variables are unstable. Besides, Dornbush's sticky price model can be consistent with the presence of a long-run equilibrium under a statistical specification.
Fountas and Wu (1999), who studied the relationship between the real exchange rate and interest rate in European countries from the sample 1979 to 1993. The studies have been conducted test by cointegration. The main finding in their sample shows that there is strong evidence in favor of bilateral real interest rate convergence between Germany and several countries, especially for long term real interest rates. However, European countries monetary policy has lost some of its effectiveness as stabilization policy tool due the result carried the important policy implication.
Last but not least, Hacker, Kim and Mansson (2010) measure the relationship between exchange rate of Swedish Krona and interest rate by employs the wavelet analysis to investigate the causality in a Granger sense at different time scales. When using monthly data, they found that there is an opposite direction in the result. The result shows some evidence of more negative relationship between exchange rate and interest rate in the short run. However, there is more positive relationship at the long run.
2.1.5 Fourth Independent variable: Trade Balance
Among the theory related to the effect of exchange rate on trade balance, there is one popular theory called elasticities approach. In the framework, one of the assumptions is prices to be sticky. However, elasticities model, which is the Marshall Lerner (ML) condition, to the trade balance adjustment is unfulfilled in open economies. One of the assumptions stated that the initial trade account must be zero. In fact, countries like China, Japan, and other East Asian countries have gathered up gigantic amount of outside wealth due to the consistent trade surpluses over years.
The first research regarding the relationship between exchange rate and trade balance is Bickerdike (1920) and then it continued with Robinson (1947) and Metzler (1948). As a result of these three research papers, the well-known Bickerdike-Robinson-Metzler (BRM) approach or the elasticities model to the balance of payments occurred.
According to the theory, the nominal depreciation or appreciation of the exchange rate is said that alters the real exchange rate (Bahmani-Oskeooee, 2001) and has an immediate effect in the trade balance. Bahmani-Oskeooee (2001) also noted that for a country to gain international competitiveness and ameliorate the trade balance, a country may conduct to devaluation or depreciation its currency. As the currency devaluate or depreciate, exports increase and become cheaper. However, the imports will be affected due to its price become relatively expensive. Thus, trade balance enhanced.
In fact, numerous studies have been conducted to identify the relationship between exchange rate and trade balance in both developed and developing countries. However, the conclusions have been inconclusive and unclear. Some of the studies have figure out that there is an existence of a relationship, while others have been shows the otherwise. Explicitly, Liew, Lim and Hussain (2003) have examined the trade balance between ASEAN-5 countries plus Japan for the period started from 1986-1999, the result shows that trade balance is influenced by the real money, rather than exchange rate.
Duasa (2007) also measure the relationship between trade balance, income, money supply and real exchange rate in Malaysia economic from 1974 till 2003. By employing the cointegration and error correction approaches, further inferences from variance decomposition (VDC) and impulse response functions (IRF), results show that there is no evidence of long run relationship between exchange rate and trade balance. In addition, Marshall-Lerner conditions do not hold in Malaysia for longer term.
Moreover, Aurangzeb and Ul Haq (2012), investigates the element affecting the trade deficit in Pakistan from 1981 till 2010. By using multiple regression analysis to measure the significance of factor, result shows that there is a negative relationship between exchange rate and trade deficits. However, gross domestic production, remittances and foreign direct investment imply a positive relationship with trade balance.
Chiu, Lee and Sun (2010) employs the heterogeneous panel cointegration model to measure the long run relationship between the real exchange rate and bilateral trade balance of U.S. and her trading partner during the sample of 1973 till 2006. The result shows devaluation of the U.S. currency worsens the bilateral trade balance with 13 trading associate, but ameliorate it with other 37 associates. In short, there is a long term negative relationship between the real exchange rate and bilateral trade balance for U.S.
Shirvani and Wilbratte (1997) examine the relationship between the real exchange rate and the trade balance from 1973 till 1990, using the Johansen-Juselius multivariate cointegration model. The empirical result shows that the bilateral trade balance between U.S. and other G7 countries were insensitive in the short run but significantly influenced by it within two years period. Besides, it consistent with the Marshall-Lerner condition, signalling that devaluation improves the long run trade balance.
However, Ling, Mun and Mei (2008) study the relationship between the real exchange rate and trade balance in Malaysia from the sample between 1995 till 2006. The studies have been conducted tests by employed Unit Root Tests, cointegration model, Engle-Granger techniques, vector error correction model (VECM) and impulse response analyses. The main findings show that there is an existence of long run relationships between trade balance and exchange rate. It also consistent with the Marshall-Lerner condition, but indicate that there is no J-curve in Malaysia situation.
Onafowora (2003) have conducted the similar studies about the short run and long run relationships between real exchange rate changes and real trade balance of three ASEAN countries in their bilateral trade to the U.S and Japan by using the cointegrating vector error correction model (VECM). Results show that there is a long run relationship among trade balance, real exchange rate, real domestic and foreign income in each countries. Impulse response response indicate that the Marshall-Lerner condition do holds on the long run but with a changing angle of J-curve effects in the short run.
Waliullah, Kakar, Kakar and Khan (2010) intend to identify the short and long run relationship between trade balance, income, money supply and real exchange rate in Pakistan's economy. They have conducted the cointegration and error models, developed within an autoregressive distributed lag (ADRL) models during the period from 1970 to 2005. The results show that there is a constant long run relationship between trade balance and income, money supply, and exchange rate. In addition, exchange rate depreciates will have a positive effect to the trade balance in the long and short run, congruent with Marshall-Lerner condition.
Yusoff (2007) using the cointegration measure to identify both the short and long run relationship between the real trade balance and the real exchange rate, domestic and world incomes in Malaysia. This paper has been use quarterly data started from 1977 till1998. The results indicate that there is a long run relationship between trade balance and real exchange rate, domestic and foreign incomes in Malaysia. VECM also show that exchange rate is important determinant of the trade balance in the short run. However, there is a delayed J-curve in this case.
Lal and Lowinger (2002) identify both the short and long run determinant of trade balance in five South Asian countries, employing quarterly data from 1985 till 1998. The results suggest that there is an existence of both short and long run relationship between nominal effective exchange rate (NEER) and trade balances. Aziz (2008) also performed the estimation of the effect of exchange rate in the trade balance in Bangladesh. By applying the Engle-Granger and Johansen models to examine the long term cointegration relationships, and followed by Error Correction Mechanism (ECM) for short run linkage during the period from 1972 till 2005. The results show that the real effective exchange rate has a positive effect on trade balance.
Lastly, Shao (2008) also conducted the research about the economic factor the influence the bilateral trade balance between Japan and U.S. The sample period for this estimation started from 1980 till 2006 by using the quarterly data. The Johansen and Juselius result demonstrates that there exists a long run relationship between exchange rate and trade balance.
2.2 Review of Relevant Theoretical Models
This section will states the different kind of useful theories which able applied to our four independent variables -foreign direct investment, inflation rates, interest rates, and trade balance. We will choose the most suitable theories as our theoretical framework in the following section and those theories will enable our hypothesis being tested and work out in our research.
2.2.1 Foreign Direct Investment
22.214.171.124 Appreciation or depreciation of exchange rate
According to Dhakal et al (2010), foreign investors may gain or lose from a depreciating exchange rate. For instance, a depreciating exchange rate may boost exports and provide gains from resource-seeking FDI. Foreign investors, however, may lose as well because they must incur costs to prevent transaction and translation losses when currencies depreciate. If they believe that depreciation will continue after they enter a country, they may conclude that the costs will be too high to justify their investments.
126.96.36.199 Net foreign assets (NFA) (+/-)
According to Sidek, Yusoff & Munir (2009), net foreign asset is subjected to two contrasting interpretations. First, this variable reflects the external position of a country. Higher borrowing or inflow of foreign direct investment can worsen a country's net foreign asset position. This requires the currency to depreciate which indirectly promotes international price competitiveness of a country's exports. Second, NFA also captures the impact of capital flows into a country. Therefore, the ambiguity of how these fundamental variables affect the ringgit warrants empirical research.
188.8.131.52 Macroeconomic volatility
According to Udoh & Egwaikhide (2008), FDI, like other forms of investment, also depends on non-economic factors such as risk, macroeconomic volatility, and then FDI is a forward-looking activity based on investors' expectations regarding future returns and the confidence that they can get back on these returns at specific period. These variables increase uncertainty and discourage investment. For examples if price elasticities are low, exchange rate depreciation effects could be perverse. Second, it is usually associated with uncertainty and exchange rate risks. Third, fluctuations in the exchange rate can result in significant reduction in the value of assets invested in the host country as well as the future profits generated by the investment.
2.2.2 Inflation Rate
184.108.40.206 International Fisher Effect
International Fisher Effect (IFE) theory shows that the foreign currencies with relatively high interest rates will tend to depreciated as the high nominal interest rates reflect expected rate of inflation. The way that nominal interest rate affect the inflation rate is known as the Fisher effect in literature and it is relatively important to the efficiency of the financial market and monetary policies performance.
Besides, International fisher effect theory states the differences in anticipated inflation that embedded in nominal interest rates are expected to affect country's future spot rate in exchange market and it shows that there is a relationship when exchange rate changed relatively with the changes in interest and inflation rates.
Utami and Inanga (2009) have proved that any changes in nominal interest rates will tend to change the expected rates of inflation. Fisher equation implies that the nominal interest rate is equal to the real interest rate plus the expected rate of inflation. For instant, IFE theory states that suggest that relatively high interest rates of foreign currencies will depreciate because the high nominal interest rates tend to reflect expected inflation.
220.127.116.11 Purchasing Power Parity
Purchasing Power Parity was representing a fundamental concept in exchange rate modeling. This theory reflects the equality between exchange rate modifications and price indices differential among countries. This theory was elaborated by Gustav Cassel 1932 and it was empirically developed until today. It can be divided into two versions which are absolute PPP and relative PPP. For the absolute version, the main idea is the real price of good must be in the same in all countries which obey the law of one price, where the relative PPP is the most commonly used version of PPP, which states the exchange rate between any two countries will adjust reflect to the changes in the price levels of the countries.
The purchasing power parity theory of Cassel stated that the monetary factor was the most important long run determinations of the exchange rate under a flexible exchange rate standard. PPP is important in analyzing the real exchange rate behavior. It's proved by the real exchange rate can be computed as a multiplication between nominal exchange rate and the ratio between foreign and national prices.
According to Mungule (2004), behavior of the exchange rate is relatively related to the behavior of deviations from purchasing power parity (PPP). He investigate on purchasing power parity theory which states that rate of change in the nominal exchange rate is equal to domestic inflation minus the foreign inflation rate and the results suggested that the simple notion of the PPP may hold.
2.2.3 Interest Rates
18.104.22.168 Flexible-Price Monetary Models
According to Frankel (1979), product prices are perfectly flexible in the assumption of asset-approach exchange rate determination models and perfect substitutions for bonds within different countries are known as flexible-price monetary models. These models are determined the long-run relationship and its state that the positive relationship should be existence between the interest rate differential and the exchange rate. The positive relationship exists because as a consequence of the flexible-price assumption which assume changes in the nominal interest rate reflect changes in the expected inflation rate. Reduction in the money demand will be occurring when the domestic interest rate rises as the investors will put more of their portfolio in interest rate bearing assets such as treasury bills. Besides that, it will also increase country's aggregate demand which will cause higher prices in the domestic country and the exchange rate will rise through the relative purchasing power parity.
22.214.171.124 Sticky Price Models
According to Hacker, Kim and Mansson (2009), sticky-price models also known as Keynesian theory as it assumes the prices are sticky in the short run and these models rely heavily upon the exchange rate as an equilibrating variable to maintain zero balance of payment. The hypothesis of sticky price models state the negative relationship should be existence between the interest rate differential and the exchange rate. The higher domestic interest rate will attract a capital inflow when the domestic interest rate rise relative to the foreign interest rate and will cause the domestic currency to appreciate immediately.
126.96.36.199 International Fisher Effect
According to Sundqvist (2002), International Fisher Effect is the combination of the generalized version of the Fisher Effect and relative version of the Purchasing Power Parity. This theory conclude that foreign currency will be appreciate against the domestic currency when the domestic interest rate is higher than foreign interest rate since low foreign interest rate reflects low inflationary expectations in the foreign country. On the other hand, when the domestic interest rate is lower than foreign interest rate, the foreign currency will be depreciate against the domestic currency.
2.2.4 Trade Balance
There is a conventional approach of identifying the effect of currency devaluation or depreaciation on the trade balance based on the well-known Marshall-Lerner (ML) condition. The Marshall-Lerner condition was named after three economists who discovered it independently. There are Alfred Marshall (1842-1924), Abba Lerner (1903-1982) and Joan Robinson (1903-1983). The main objectives of these condition were to found out whether when a devaluation or depreaciation of the currency ameliorate the current account balance of the countries.
Marshall Lerner condition postulates that there is an improvements of the trade balance if the sum of the elasticities of demand for imports and exports is greater than one. The short run and long run of elasticities of the trade balance will ultimately leads to J-curve effect. It stated that a real devaluation or depreciation will intially affect the current account balance in the short term, however it will ameliorate in the long term when the Marshall-Lerner condition is met. The J-curve concept which was introduced by Magee (1973) states that the rationale of the short run effect which deteriorates the trade balance intially and improve afterwards is because of the adjustment lags. Bahmani-Oskooee and Ratha (2004) also provided a detailed review of literature in this studies.
Proposed Theoretical/ Conceptual Framework
Figure 2.1: Relationship between Malaysia's Foreign Exchange Rate and Four Independent Variables.
Figure 2.1 shows the dependent variable and all the four independent variables which included in this study. The dependent variable is RM against US Dollar from period 1971 to 2010 while foreign direct investment, inflation rate, interest rate and trade balance as independent variables in the study. We will examine the relationship between those variables by using different types of econometric method and we will state and further explain the method in Chapter 3.
The main objective in this research paper is wished to find out what are the relationship between the Malaysia's exchange rate and four macroeconomic variables namely foreign direct investment, inflation rate, interest rate and trade balance. Hence, the following hypotheses are developed in order to achieve research objective.
2.4.1 Foreign Direct Investment
Based on the research done by Idris 2009, Pham 2010, Soo 2010, Ngie 2009 and Chen 2011, stated that there is positive relationship between exchange rate and foreign direct investment. While according to other researcher such as Nazima 2011, Elijah 2008, Dharmendra 2010, Agnes 2001 and Rana 2010, they demonstrate that there is negative relationship between exchange rate and foreign direct investment. Therefore, this research paper hypothesize that there is a relationship between exchange rate and foreign direct investment.
H0: There is no significant relationship between exchange rate and foreign direct investment
H1: There is significant relationship between exchange rate and foreign direct investment
The null hypotheses described that the exchange rate and foreign direct investment is no have any significant relationship between each other. While the alternative hypotheses described that there is significant relationship between the exchange rate and foreign direct investment.
2.4.2 Inflation Rate
Based on the research done by Mishkin (1984), Anichebe Alphonsus S. (2011), Kamin and Klau (2003) stated that there is a relationship between exchange rate and inflation. Furthermore, R.Bautista (1983), Josef T. Yap (1996) found out that an increase in inflation or decrease in purchasing power parity will cause the currency to depreciate. Hence, this research paper hypothesize that there is a relationship between exchange rate and inflation.
H0: There is no significant relationship between exchange rate and inflation
H1: There is significant relationship between exchange rate and inflation
The null hypotheses described that the exchange rate and inflation is not significantly related with each other while the alternative hypotheses described that there is a significant relationship between the exchange rate and inflation.
2.4.3 Interest Rate
According to Utami and Inanga (2009), they find that there are week relationship between the interest rate differential and exchange rate for USA, Singapore and UK relative to Indonesian. However, the empirical result in Yu Hsing (2007) paper shows that there is negative relationship between the nominal exchange rate in Egypt and the foreign interest rate. Hence, we estimate that there is a relationship between exchange rate and interest rate.
H0: There is no significant relationship between exchange rate and interest rate
H1: There is significant relationship between exchange rate and interest rate
The null hypotheses described that the exchange rate and interest rate is not significantly related with each other while the alternative hypotheses described that there is a significant relationship between the exchange rate and interest rate.
2.4.4 Trade Balance
Based on the research done by Liew et al. (2003), Duasa (2007), Aurangzeb and Ul Haq (2012) and Chiu et al. (2010) stated that there is no relationship between exchange rate and trade balance. While according other researcher such as Shirvani and Wilbratte (1997), Ling et al. (2008), Onafowora (2003), Waliullah et al. (2010), Yusoff (2007), Lal and Lowinger (2002), Aziz (2008) and Shao (2008), it demonstrates that there is an existence of relationship between exchange rate and trade balance. Therefore, this paper hypothesize that there is a relationship between exchange rate and trade balance.
H0: There is no significant relationship between exchange rate and trade balance
H1: There is significant relationship between exchange rate and cash balance
The null hypotheses described that the exchange rate and trade balance is not significantly related with each other while the alternative hypotheses described that there is a significant relationship between the exchange rate and trade balance.
The studies of impact of foreign direct investment, inflation, interest rate and trade balance on exchange rate have been the central of debating between researchers. Numerous literatures have been carried out to study the relationship, yet the result is still inconclusive and ambiguous. Indeed, empirical evidences have proved that each of the method and results has its own supporters, resulting in controversy of independent variables theories. It is important to note that different level of the exchange rates may react differently of interest rates, inflation rates, foreign direct investment and country balance of payment, which helps to explain the controversy in those theories.
In conclusion, we have been reviewed the relevant theoretical models on the impact of foreign direct investment, inflation rates, interest rates, and trade balance on exchange rates. Reviewing on the relevant past literatures and theoretical models enables this study to propose theoretical frameworks and develop hypothesis which are to be used to study the main objectives of this research paper. The stated theoretical framework and hypothesis will be further tested and explained in Chapter 3 and Chapter 4 respectively.