The relationship and effect between exchange rates with interest rates

LITERATURE REVIEW

This study relates to examine the relationship and effect between exchange rates with interest rates. Numbers of studies have done by the researchers, ‘Robert A. Mundell, (1961)’, ‘Bela Balassa (1964), ‘Robert Z. Aliber, (1973)’, ‘Rudiger Dornbusch, (1976)’, ‘Richard A. Meese & Kenneth Rogoff (1982)’, ‘H.M.S Gerlach (1988)’, to investigate the determinants of exchange rates have applied in the world exchange rates market and help for different countries in their market development and economic growth. Researchers attempted to exemplify whether, how and to what extent the determinants of exchange rates market can contribute to the process of economic growth.

Purchasing Power Parity Theory

The purchasing power parity theory doctrine means different things to different people. It has two versions of this theory that can be called the ‘absolute’ and the ‘relative’ interpretation. The first version of purchasing power theory calculated as a ratio of consumer goods prices for any country would tend to the equilibrium rates of exchange. In the second version of relative interpretation the rate of exchange rate would be determined between two countries and quoted with general levels of prices of two countries. It amend the international trade theory which would be the part of PPP, in which introducing the non-traded goods (services), but the advantage is greater in regards of traded goods than non-traded goods, because of the assumptions of marginal rates of transformation. The relationship between purchasing power parity and exchange rates provides the international comparison of national incomes and living standards (Bela Balassa, 1964). (Lawrence H. Officer, 1976), is the researcher which gave another review of this purchasing power parity theory. It has define two applications in economics, the first application use of the conversion factor to transfer the data in one national way to another. The use of PPP is mainly the body of (index number theory) and applications of GDP that have improved over the years and path breaking studies in the area continue to appear. The second application of PPP has not the widespread acceptance, which has remained the unsophisticated applications.

A.C. Stockman, (1980),

develops the model of determination of exchange rates and prices of goods. The changes in prices of goods due to supply and demand would affect the changes in exchange rates with deviations of purchasing power parity. The changes in exchange rates have failed to resemble the changes in prices of goods, because exchange rates more volatile than prices levels and inflation rates. The paper proposes the equilibrium of exchange rates behavior and different international goods that would have been traded. This relationship cannot be exploited by the government, because the greater the changes in terms of trade the larger the changes in exchange rates variability. The deviations from PPP persist that variation of exchange rates more than ratios of price indexes. The results found the two interpretation of the relationship between exchange rates and terms of trade. In the first, the causes that affect the changes in exchange rates would also affect the change in terms of trade because prices of goods do not adjust to clear the markets. This interpretation would also found in the papers of ‘Dornbusch (1976)’, and ‘Isard (1977)’, they formally differentiates the system with respect to exchange rates and allow prices to change but not the changing in asset stocks. The another interpretation presented the elasticity approach of the foreign exchange market and the relation between the trade and exchange rates. Real supply and demand shocks affect prices and the derived demand of exchange rates. The affect of such a shift has the advantage to raise the value of currency in terms of foreign currencies relative PPP. These changes in demand for foreign exchange would result the supply and demand shocks and that should affect the equilibrium of exchange rates. In second interpretation the expected rate of change of exchange rates revealed on the forward foreign exchange market. This should be related the anticipated change in the terms of trade and the inflation differentials. A persuasive argument about the level of exchange rates is only associated with not causes of the relative prices changes.

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Clas Wihlborg, (1982),

examined the relation of interest rates, exchange rate and currency risks in this research. It identifies the test which empirically impact of currency on interest rates and exchange rates. In this research there are three different ways in which the importance of currency risks for interest rate and exchange rate determination. First different risk characteristics of assets denominated in different currencies. Second changes in the level of risks that affect the elastic ties of substitutes among different assets and the monetary policy. Third changes in the level of risks on alternative assets which have a direct impact on rates of return. This paper used the three specifications of the dependent variable to test the theory, first rates of return adjusted for the expected rate of change of the exchange rate, second difference between nominal rates of interest and third rate of change of deviation from the exchange rate. The results presented here that substantiate the changes in the level of currency risk have a nonnegligible impact on the rates of change of exchange rates and on relatives’ rates of interest between currencies. The risks explain the small share of variation in these variables. Another results indicate that the nominal interest rate seem to adjust in fiscal policies and savings behavior but not affect real rates of interest. But changes in relative risks level would affect relative rates on interest these changes still be important for the substitutability between assets of different currency denominations.

Richard Meese & Kenneth Rogoff, (1983),

analysis the out of sample forecasting accuracy on various models. It estimated the twelve month horizons for the dollar/pound, dollar/mark, dollar/yen and trade weighted dollar exchange rates. It’s also studied the candidate flexible price and sticky price monetary models, and a sticky price model which incorporates the current account. The first model is structural models in which require forecasts of their explanatory variables in order to generate forecast of the exchange rate. It has explanatory power, but predict badly because their explanatory variables are themselves difficult to predict. The second is the univariate time’s series model in which identify a variety of prefiltering techniques involve differencing, deseasonalizing and removing time trends. The relative performance of these techniques is of interest in itself. The third model use is the random walk model; it should also link with this univariate time series model. It uses as the predictor of the current spot rate with the entire future spot rate, and it requires no estimation. It performs no worse than estimated univariate time series models, or our candidate structural model. From a methodological stand point the view that the out of sample model fit is an important criterion when evaluating exchange rate, but the out of sample failure of the estimates time series models that major country exchange rates are well approximated.

John Bilson, (1985),

gives the empirical findings about macro economic and flexible exchange rate of the U.S dollar related to PPP theory. From the perspective of this paper in which sluggish price adjustment in the commodity markets resulted in increased variability in exchange rates. For the demonstration of result it is important because the instability of floating exchange rate could be due to the inherent differences between commodity and financial markets. It is impossible to determine the expected future rate because it is more difficult to reject the forward parity condition. The major part of the forward parity is the variation in the premium is due to the forecast. The object of this research is to determine that if the forward parity failed is the cause of instability in the same way that the failure of purchasing power parity. The findings develop that currency risk premium is the important factor relative to floating rate system, and movement in the exchange rate are dominated by the non speculative activity and it has the adverse effect on world economy.

Roger D. Huang, (1987),

evaluate that the expected change in the exchange rate of two countries equals the expected differentials in their inflation rats over the same holding period. It makes the empirical evidence link with PPP theory and obtained that expected nominal exchange rate changes appear to deviate systematically from inflation rate. It relates the PPP based on the constraint that, in efficient market the net return to speculators engaging in speculation on goods in the foreign country. The purpose of this paper is to know the equality restriction between expected nominal exchange rate and expected inflation rate differentials. The investigation should have the result that the evidence is inconsistent with the major industrialized countries over the current floating exchange rate. Since the test perform meaningful in conjunction with market efficiency and simply indicate the failure expectations.

John Doukas & Abdul Rahman, (1987),

conducted the unit root test for the presence of evidence from the foreign exchange futures market, and gets the representation of foreign exchange currency future prices. The paper describes the procedure from the foreign exchange future markets on five different currencies with varying maturity. It was found that presence in the series may cause the OLS estimates and its true value leading to errors, for small sample sizes the model has smaller forecast error. The process generate the log of currencies future rates by random walk, and it is consistent with other model of asset price determination that they imply the mean and dispersion of returns that don not change over short time period. But in general if follow the random walk; it is line with (Meese & Singleton’s) findings from the spot and forward exchange market.

H.J. Edison, (1987),

addresses that whether PPP is valid in the long run movements in exchange rates, though it is failed in the short run. However number of studies was conduct for the behavior of exchange rates, ‘Alder & Lehmann (1983)’, ‘Frankel (1986)’, developed more statistical techniques to examine the validity of exchange rates in the long run. Both of these have provided the evidence that PPP does not hold the exchange rates behavior in the long run. This paper also incorporates the error correction mechanism and discusses the empirical results which generally show the result of failure of exchange rate support by PPP in the long run. In general, the result indicates the force which exists in the economy for driving the exchange rates towards the PPP equilibrium. The main conclusion from this paper is the PPP relationship does not represents the exchange rates n the long run holding, so that the PPP permanent deviations cannot ruled out. This shows the reinforcement of PPP theory that was tested the fixed rate counterpart and the equalization of prices across countries, and it supports a interpretation of the PPP doctrine. This proportionality between the exchange rates and price level emerges in the long run.

Richard Meese & Kenneth Rogoff, (1988),

in their another research examined the relationship between real exchange rates and real interest rate differentials in the United States, Germany, Japan, and the United Kingdom, based on the joint hypothesis that domestic prices are sticky and monetary disturbances are predominant, and finds little evidence of a stable relationship between real interest rates and real exchange rates. It is true that in many cases the sign of the estimated exchange rate and interest rate differential relationship is consistent with the possible predominance of financial market disturbances, but the relationship is not stable enough to be statistically significant. In Quasi reduced form real exchange rate models, examined the real versions of alternative rational expectations monetary models of exchange rate determination. In the nominal rate models, the exchange rate depends on fundamentals such as relative national money supplies, real incomes, short-term interest rates, expected inflation differentials, and cumulated trade balances. One rationale for this view is that, if the poor performance of the nominal exchange rate regressions is primarily attributable to money demand disturbances, there can still be a close correlation between real interest differentials and real exchange rates, because, in the class of monetary models considered here, unanticipated money demand disturbances affect both variables proportionately.

Feinberg & Seth Kaplan, (1992),

evaluate and interact that, an index of real exchange-rate expectations is developed and used to explore its role in determining domes- tic producer prices. The fact that time path of the exchange rate will directly affect the input costs, and the price of substitutes strongly. To examine the links between both actual and anticipated movements in the dollar and relative domestic producer prices, it chooses to analyze price responses to real exchange rate changes. The extent of this effect is dependent on the nature of substitutability between imports and domestic goods. The major finding is that the period of appreciation and depreciation over the past 10 years to inhibit the pass through in to domestic prices. In depreciation the market share to enjoy the continued good times kept prices other than expected.

Warren Bailey & Peter Chung, (1995),

considers the study that the impact of exchange rate fluctuations and political risk on the risks premium reflected in cross sections of individual equity returns. The evidence suggest common factors in emerging market equity, currency and sovereign debt markets, and several implications for corporate and portfolio management. If price levels and exchange rate are significantly volatile and cannot be costly hedged, are adversely affected in the real value of the domestic currency. Some evidence that exchange rate fluctuations are a priced factor in cross sections of stock return converted into a common currency. The purpose of this paper is to explore the impact of exchange rate fluctuations and political risk on stock process of individual companies from the same country. The extent of measurement is that, which exposure factors explain cross sections of returns on individual securities and industry portfolios. The result suggests that the exchange rates and political risks could be significant in equity markets. The result also suggests that the risk premium can be time varying and not be detected by assuming constantly. This paper shows the results that it did not find the evidence of the equity market premiums for the currency and political risk. It complements the importance to attach the exchange rates and political risk in the international finance.

J.R. Lothian & M.P. Taylor, (1996),

examines the real exchange rate behavior, and explain the variations in sample of stationary univariate equations in real exchange rates. It investigates the additional insight in the exchange rates behavior that can be gained by considering the floating rate from the perspective of the data. These issues can be best understood on the subject of real exchange rates stability between the currencies of the major industrialized countries. Some of the pre-float studies support the fairly stable exchange rates in the long run. Subsequently, ‘Dornbusch (1976)’, ‘Frenkel (1981)’, gave largely as the result of studies published, and reject the hypothesis of random walk behavior of real exchange rates. The PPP shows the empirical movements in real exchange rates were highly persistent and effective; although the PPP is reject the hypothesis of non-stationary behavior of real exchange rates in the long run. The result of this paper, shows that the longest span of two countries exchange rates are significantly mean reverting. The first model result indicates the 80 percent of the variation in the exchange rates of the history data of two countries. By using of another model, the results explaining the performance of remarkably well in the floating, so that they produce better forecasts of the actual exchange rates. In line with recent studies, it fined that this process of mean reverting is quit slow, with estimated adjustment of data. In the long run the PPP equilibrium is remaining a useful empirical approximation. The deviations of the PPP that observe is consistent with the existence of slowly mean reverting influences, which may be real or monetary regimes.

Theory of Optimum Currency Areas

The theory of optimum currency areas, which is usually presented the other name called flexible exchange rate system, but it is proponents as a device of depreciation that take the place of unemployment when the balance of payment is deficit and appreciation when it replace inflation when it is surplus. The problem can be exposed and more revealing by defining a currency area within when exchange rates are fixed. To this three answer can be given; first certain parts of the world are going processes of economic integration, so new experience can be made and at what constitutes the optimum currency area can give the meaning of these experiments. Second those countries that have flexible exchange rates are likely to face problems with the theory of optimum currency areas, if the national currency does not coincide with the optimum currency area. Third the idea that illustrates the functions of currencies which have been treated in economic literature, and sometimes neglected in the problems of economic policy. In the currency area, different countries including national currencies interact pace of employment in deficit countries by the willingness of surplus countries to inflate. The argument for flexible exchange rate system is based on national currencies, and is valid about factor mobility. If factor mobility is high in the country and low internationally, a system of flexible exchange rates on national currencies might work effectively. The concept of optimum currency area has practically applicable only in areas, where political organization is in a state. The factor mobility is most considered is more relative rather than absolute concept, with both industrial and geographical. It likely change over time with alterations in political and economic conditions. Money is the convenience that restricts the optimum number of currencies, so in terms of this argument the optimum currency area which is composed in number of countries. (Robert A. Mundell, 1961). In another review the author define the capital mobility stabilization policy under fixed and flexible exchange rate; it concerns the theoretical and practical approach of the increased mobility of capital. It assumes the degree of mobility when a country cannot maintain an interest rate different from the level of abroad. The perfect mobility can be taken is to mean that all securities in the system are perfect substitutes, because different currencies are involved, and there exchange rates expected to persist indefinitely, but the forward and spot exchange rate are identical. It identify the monetary and fiscal policy, in which monetary policy assumed the open market purchase of securities while fiscal policy is to form of increase in government spending and financed by an increased in public debt. Its effect the floating exchange rate result when monetary policy does not intervene in the exchange market, but it intervene the fixed exchange rates, when government buy and sell international reserves at a fixed price. The results of this paper analyze that, monetary policy under fixed exchange rates becomes a device for the levels of reserve, whereas the fiscal policy under flexible exchange rates becomes a device for the balance of trade, but policies are unaffected to the level of output and employment. The perfect mobility will lead to the breakdown of the fixed exchange rate system as the absence of gold sterilization. The gold sterilization is frustrated the capital outflows and offsetting monetary changes through the exchange rates equalization. The conclude remarks is that, the monetary policy is ineffective under fixed exchange rates as compared to flexible exchange rates, but fiscal policy under both fixed and flexible exchange rates remains weaker of achieving the level of output. Fiscal policy can expected to play some role in employment policy under flexible exchange rates, and monetary policy can have influence on output under fixed exchange rates, but if this possibility exist it will lesser extent in the future. (R.A. Mundell, 1968).

Jeffrey A. Frankel, (1979),

defined that most of the recent work on floating exchange rate goes under the name of the monetary or asset view; the exchange rate has moving to equilibrate the international demand for assets, rather than the international demand for the flow of goods. But with the asset view there are two approaches. The first approach is ‘Chicago Theory’ in which assumes that prices are perfectly flexible. As the consequences when nominal interest rate changes it’s reflect the changes in expected inflation rate, so as the domestic currency expected to loose value through inflation and depreciation. This is the rise in the exchange rates and gets the positive relationship between positive exchange rate and nominal interest rate differentials. The second approach is ‘Keynesian Theory’; it assumes that prices are sticky in the short run. As the consequences changes in the nominal interest rate reflect changes in the tightness of monetary policy. The higher the interest rate in the country attracts the capital inflow, which causes the domestic currency appreciates, so this gets the negative relationship between the exchange rate and nominal interest rate differentials. This paper develops a model of the asset view of the exchange rate, which emphasizes the role of expectations and adjustment in capital markets. It says that the increase in income or a fall in the expected rate of inflation raises the demand for money and lowers the exchange rate.

H.M.S Gerlach, (1988),

examine the dynamic interrelationship between innovations in monthly industrial production in a set of economies, specifically this paper attempts the output fluctuations that have been correlated during the periods of fixed and flexible exchange rates. The current has to managed exchange rates flexibility would reduces the interdependence across countries. It should follow the recent article of ‘Flood and Hodrick (1986)’ in which argued that the variability would be higher during a regime of fixed exchange rates instead of flexible exchange rates, but their conclusion striking so sharply. It should be clear by this paper that does not test any hypothesis which would concern the importance of exchange rate regime, but it should establish some statistical regularity with respect to the output during the recent periods of fixed and floating exchange rates. The results of this study of multi country output movements under fixed and flexible exchange rates are clear. The variances of growth rates should be higher in the flexible exchange rates and in the fixed exchange rates periods. These variances are statistically significant related to the degree of openness and national income. Thirdly the output movements are correlated across countries under exchange rate regime, particularly the co movements in output are more important in the business cycle frequently during the recent years of managed exchange rates flexibility.

M. Obstfeld & K. Rogoff,

(1995), analyses the global macro economic dynamics to supply framework based on competition and nominal prices. This paper incorporates the prices rigidities that explain exchange rate behavior without insights of the intertemporal approach to the current account. The effects of macro economic policies on output and exchange rates have not been yet persuaded to abandon. The framework which integrated exchange rates dynamics and current account yields is a new perspective, it realize that when prices are sticky the government should spend on shock raises short run output and long run output. The assumption is that home and foreign government purchases the consumption goods that do not directly affect the private utility, but the per capita real government consumption expenditure is a composite consumption of individual goods. Its explain that the composite consumption for the services is to balance the opportunity cost and notice that the money depends on consumption rather than income, that distinction is more important in closed economies. The results of this paper develop framework that give new foundations about some of the fundamentals problems in international finance. It realizes that the existing Keynesian model is incomplete to offer a satisfactory treatment of exchange rates, output and the current account, but the model which is used in this research is more complex, because its yields simple and intuitive insights of monetary and fiscal policies. It can be extended in a number of dimensions, including non traded goods, market behavior, government spending, and labor market distortions and so on. Its goes beyond the essentially statistical approach that handles the current account and exchange rates issues, most importantly this approach allows to analyze the welfare implications of policies.

Charles Engel, (2001),

examines the exchange rate policy in two countries sticky price in which households and firm optimize horizon an environment of uncertainty. Under this condition the fixed and floating exchange rates yield higher and depend on nature of price stickiness on the risk sharing opportunities. It also presents some empirical evidence on the behavior of consumer prices in Mexico that suggests failures. This price setting and risk sharing opportunities is not refined and make definitive conclusions about the optimal exchange rates regime. The approach of fixed and flexible exchange rates regimes are in the short run stabilizing properties. The famous ‘Friedman’s (1953)’ argued that floating exchange rates are stipulates in the long run, and the exchange rate system does not have real consequences, he identify the case for flexible exchange rates as a vehicle for rapid changes in international prices. The floating exchange rates are in the presence of capital mobility, become more complicated and depending the sources of shock which was monetary and the degree of capital and factor mobility. This paper following ‘Obstfeld and Rogoff, (1998)’in that way that firms sets prices to maximize the value of the firm, there are three types in which prices are sticky, firms set prices in their own currencies, sets prices in consumers currencies, and some sets prices in producers currencies. For this reasons the prices of the goods should be different because is fixed within the country where the goods is produced, but the price varies according to the exchange rate risk for foreign consumers. In a world of perfectly flexible prices, the devaluation would not necessarily any real change in wealth, but in the short run with sticky prices the nominal devaluation are real devaluations. The results stabilizing that the properties of exchange rates regimes and their effects on the efficiency level of the economy are dependent on the price setting. The price setting behavior interact the financial markets, that which have seen the law of price holds for all goods and there is complete consumption in the absence of asset trade. This result also emphasize on role of price setting and capital mobility. The degree on which capital mobility not matter for the choice of exchange rate, so it depend the goods prices are set. Finally it should describe that any currency to set prices it may well depend on the exchange rate regime and the capital markets.

Interest Rate Parity Theory of Exchange Rate

This simple interest rate parity theory is the adjustment of the discount, or premium on forward exchange rates with the short term interest rate differentials between home country and foreign country. If the short term interest rate of foreign country is high in home country, it will profitable of funds in foreign country, and it will covered exchange risk, when this equilibrium exists, so the interest parity established. The usual comparison of interest parity are equal, this will approximate equality between interest rate differential and the forward exchange cover. The demand and supply of interest arbitrage to be equal at forward exchange rate, but the forward rate falls when the interest arbitrage supply is equal to demand. In the present context, the flow of interest arbitrage funds will cause a larger discrepancy from interest parity than would obtain. The explanations that emphasize the limited amount of arbitrage funds have different policy implications, where interest differentials are wide in the forward market. This mobility desired interest rates at home and abroad are more closely aligned. (John H. Auten, 1963).

Jacob A. Frenkel, (1973),

specifies the revised the interest rate parity condition, this introduces the spread between borrowing and lending interest rates and assumes supply of funds. The interest rate parity theory maintains the equilibrium or discount on a forward contract for foreign exchange related to interest rates. An interpretation of the deviations from interest rate parity in terms of elasticity implies and that are very low. The low values of the elasticity imply is to be taken seriously, so then arbitragers have a relatively high monopoly power. The traditional interest rate parity can be interpreted being equilibrium; if there exist a neutral band so it could not cover arbitrage is profitable. (Robert Z. Aliber, 1973), analysis the reinterpretation of interest rate parity theorem of the behavior of foreign exchange market rely on interest rates. This theorem rely the forward exchange rates to the money market interest differentials, and it gives the F= forward exchange rates, S= spot exchange rates, and R= domestic interest rate. It identifies the participants as speculators or arbitragers basis of their position toward exchange risk. Arbitragers shift funds between national money markets and to exploit the difference between the interest rates and exchange rates. The distinction of speculators and arbitragers is conceptual. Three types of explanations are defined in this paper for apparent opportunities for an arbitrage are transaction costs, default risks and non monetary returns. This explanation involves the market imperfections in the supply of foreign exchange to speculators, because that the purchase of foreign currency is equivalent to borrowing domestic currency. The interest rate parity also is consistent with investors’ expectations when the securities are to compute the interest in terms of political risks. The interest on these securities are similar in terms of political risks can be compared with exchange rates, when the predicted and observed exchange are same. The interest also reflects payments demanded by investors for carrying exchange risk and political risks. Changes in the interest reflect of investor expectations about