Aurora Borealis
1 July 2014 CFA Institute Journal Review

The Dynamic Relationship between Exchange Rates and Macroeconomic Fundamentals: Evidence from Pacific Rim Countries (Digest Summary)

  1. Neeti Goyal

Examining the dynamic connections between exchange rates and macroeconomic fundamentals, the authors analyze the dynamic equilibrium correction and direction of causality between the two variables for 11 Pacific Rim countries.

What’s Inside?

Using an analytical framework that incorporates structural breaks and different subperiods in the data, the authors examine the connection between exchange rates and monetary fundamentals of Pacific Rim countries. The topic brings to the forefront the essence of international interdependence in the era of economic cooperation and regional integration. The authors suggest policy implications that highlight the importance of being aware of international economic circumstances when deciding a country’s monetary policy.

How Is This Research Useful to Practitioners?

Much research has already been done to demystify the relationship between exchange rates and countries’ macroeconomic fundamentals. The authors use a different econometric framework that adds to the existing research pool. They find that in a floating-rate scenario, nominal exchange rates adjust to the long-term equilibrium.

There are structural breaks in the relationship between exchange rates and macroeconomic fundamentals. Exchange rates determine or adjust in accordance with changes in fundamentals for some country pairs. The connection between the two variables in different subperiods is time varying (i.e., the connection is affected by external shocks), which implies that for some subperiods, the relationship does not persist. But for some country pairs, there is two-way causality between the variables during some subperiods.

The authors’ findings are similar to some of the latest findings in this domain. In addition, they examine the link between the two variables during the Asian financial crisis and recent global financial crisis and find that exchange rates influence fundamentals during some subperiods. The findings and implications of the research are useful for monetary policymakers and foreign exchange professionals.

How Did the Authors Conduct This Research?

For 11 Pacific Rim countries, the monthly exchange rates and macroeconomic factors data for January 1986 to December 2011 are culled from the IMF’s international financial statistics publication. To simplify the analysis, the data series are expressed in natural logarithms. The variables are nonstationary; thus, they are assumed to have unit root. The authors note that such variables should not be estimated by using ordinary regression analysis, but between them, there may be one or more equilibrium relationships, which allows the authors to estimate how many variables there are and what they are (i.e., cointegrating vectors).

To identify the integrating order for all variables, the authors first implement the conventional unit root tests without structural breaks (i.e., augmented Dickey–Fuller, Phillips–Perron, and Kwiatkowski–Phillips–Schmidt–Shin tests), and then they use Narayan and Popp’s (Journal of Applied Statistics 2010) unit root test with structural breaks. Next, they use a vector error correction model (VECM) to estimate the long-run equilibrium with short-run dynamic adjustments. This approach further extends other models to clarify the connection between exchange rates and monetary fundamentals for the Pacific Basin countries. In addition, the authors use a bootstrap, rolling window approach developed by other researchers to investigate the time variation in the causal link between the variables. Other constraints are also considered. The VECM can be extended to examine the connections between other asset prices and fundamental variables.

Abstractor’s Viewpoint

In the era of liberalization, cross-border trade, and regional integration, managing floating exchange rates is a challenge. In this regard, the authors’ findings are useful for policymakers. The research highlights that monetary policymakers react to the exchange rate when setting the money supply. Pacific Basin countries’ leaders should abandon policies that pursue short-run benefits. Instead, they should enhance the cooperative connections of finance and trade through associations or agreements, such as the Asia-Pacific Economic Cooperation, Association of Southeast Asian Nations, and Trans-Pacific Strategic Economic Partnership Agreement.

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