The Effect of the Real Effective Exchange Rate Fluctuations on Macro-Economic Indicators (Gross Domestic Product (GDP), Inflation and Money Supply)

Transcription

1 The Effect of the Real Effective Exchange Rate Fluctuations on Macro-Economic Indicators (Gross Domestic Product (GDP), Inflation and Money Supply) Havva Mohammdparast Tabas 1, Mohammad Reza Mirzaeenezhad 2, Teimour Mohammadi 3 1 M.S.c of Economic Sciences, Islamic Azad University, Central Tehran Branch 2 Assistant Professor, Islamic Azad University, Central Tehran Branch 3 Assistant Professor, Allameh Tabatabaei University Abstract The exchange rate is a variable which can affect economic variables and the economic performance of the country. Since the macro-economic indicators are interacting with each other, therefore examining the influence and impact of these indicators are very important. The present study examines the effect of real effective exchange rate shocks on macro-economic indicators (GDP, inflation and money supply) using Vector Autoregression (VAR) model, Vector Error Correction Model (VECM), Hodrick Prescott filter method with Granger causality techniques, impulse response and variance decomposition. According to the results of estimation, long-term relationship between money supply and real GDP is negative. The long-term relationship between the consumer price index (CPI) and real GDP is positive and the longterm relationship between the real effective exchange rate and real GDP is negative. The results also indicate that real GDP is the Granger causality of the real effective exchange rate, but the reverse is not true. There is a Granger relationship at confidence level of 95% from the real effective exchange rate toward the price level and the money supply. The response of real GDP and the price level toward the standard deviation of real effective exchange rate shock is negligible. However, the response of money supply is somewhat greater; the real effective exchange rate shock explains the negligible percentage of real GDP and price level. In regard to money supply, this percentage is higher than other two variables. JEL Classification: F31, E20, C22 Keywords: Exchange Rate, Real Effective Exchange Rate, Macro-Economic Indicators, Vector Autoregression (VAR), Hodrick Prescott Filter Introduction The Exchange rate as a measure of the value of the national currency against other countries reflects the economic situation of the country compared to other countries. In an open economy, the exchange rate is considered as the key variable due to its interaction with other internal and external variables. Domestic and foreign economic policies and economic developments greatly affect the exchange rate. In contrast, the exchange rate is a variable that can affect the economic performance of the country and economic indicators. One of the important issues in the field of exchange rate, especially in developing and underdeveloped countries is the effect of the real effective exchange rate on macro-economic indicators. Since the macro-economic indicators are interacting with each other, therefore examining the influence and the impact of macro-economic indicators is very important. It is assumed that the real effective exchange rate fluctuates around a long-term trend. The deviation from the trend determines the rate of real effective exchange rate fluctuations which is called uncertainty. In fact, the real effective exchange rate fluctuations lead to uncertainty in gross domestic production (GDP), inflation and the money supply. This uncertainty raises decision-making costs for economic agents. The purpose of this study is to evaluate such effects on GDP, inflation and money supply. For this purpose, Vector Autoregression (VAR) model and Hodrick Prescott filter are used. COPY RIGHT 2012 Institute of Interdisciplinary Business Research 1097

2 Literature Review Undoubtedly, the real exchange rate in each country is considered as fundamental indices to determine the degree of international competition and explaining the domestic economy. Disruption and fluctuation in the performance of this index, one the one hand, indicates an imbalance in the economy, and on the other hand is considered as the cause of more instability. Previous studies in developed countries show that the unadjusted changes in structural variables along with inconsistent fiscal and monetary policies of governments causes a distance between the real exchange rate and its equilibrium values. These studies also estimated the amount of deviation and its effect on the economic performance of developed countries. The results show that there is a strong negative relationship between indicators of economic performance and the real exchange rate disequilibrium in the developing countries. Since the behavior of the real exchange rate is the consequence of the relationship between the currency policies and performance of the basic economic variables, obviously the policies which lead to improper adjustment of the real exchange rate in the currency system cause the stop of economic movement and slow economic growth. The deviation of the real exchange rate causes impairment in estimation of the investment cost. It has led production factors toward the production of non-tradable products. It also results in transfer and allocation of resources to non-commercial and non-interchangeable activities. Increased uncertainty and encourage people, banks and industry for trading are of the effects of real exchange rate deviation on the financial markets. Through this, the production and economic growth and other macro-economic variables are also affected (Domak and Shabsigh, 1999). Fluctuations in the real exchange rate also affect the real sector through developing uncertainty in futures prices of goods and services. Economic agents make decisions in the field of production, investment and consumption according to information provided by the prices system. Unreliable and unpredictable prices due to uncertainty in the real exchange rate negatively affect decisions on production and investment. Moreover, the uncertainty in the real exchange rate leads to increased risk in the economic environment which results in increased interest rate, decreased investment and negative effect on production. In addition, increased fluctuation in exchange rate and uncertainty leads to increased risk in international trade and increases trading costs which decrease the trade and thereby reduce production (Oladi et al, 2008, p 16) In the commodities market, the positive exchange rate shocks lead to increasing the price of importing goods and decreasing the price of exporting goods, consequently this will result in increased demand for domestic goods. On the supply side, it can be argued that in developing countries, the positive exchange rate shocks (devaluation of the national currency) will result in increasing the costs of importing intermediate goods, and therefore, more expensive imports of intermediate goods (production inputs) which can increase inflation in the economy and could have a negative influence on production (Kazerooni and Rostami, 2007, p 180). Branson (1989, 433), introduced the theoretical relationship between exchange rate, price level and production as follows: theoretically, export is a function of the exchange rate and domestic price level. On the other hand, the import is a function of the domestic price level, exchange rate and domestic production. Given that the change in the exchange rate will result in some changes in exports and imports and thereby production, thus, the overall balance will be accompanied by changes in the price level. Therefore, if an increase in exchange rate or devaluation on internal currency lead to more expensive imports, the community will reduce the amount of imports and will be attracted to replace imports by domestic products. On the other hand, the cheaper exporting goods will be more attractive for the markets of other countries and result in enhancing the country's competitiveness, and thus, the rate of exports. As a result, the domestic demand increases and with constant conditions and flexibility of supply, the domestic production will increase. Moreover, it is often discussed theoretically that for a small open economy, causality between internal and external economy is from exchange rate toward the domestic price level. This would cause an overall horizontal supply curve. Therefore, this causes that the demand COPY RIGHT 2012 Institute of Interdisciplinary Business Research 1098

3 management policies in a large economy have different implications with a small open economy. For a small open economy, the expansionary monetary policy definitely has a significant impact on price, but its impact on production is uncertain. In other words, the comparative advantage of fiscal policy will be in changing the production levels, but the comparative advantage of monetary policy through affecting the exchange rate will be an effect on the price level. Given the importance of exchange rate in the economy and due to rapid changes in the exchange rate policies in the economic structure of Iran, it is necessary to study the exchange rate in Iran and its impact on the country's macro-economic variables. 1 - Model To evaluate the impact of effective real exchange rate fluctuations on the macro-economic indicators (GDP, inflation, money supply) in the Iranian economy, the Vector Autoregression (VAR) model, Vector Error Correction Model (VECM) and Hodrick Prescott method are used. The present study has been done for I.R. Iran. The required statistics and data include time-series economic indicators, balance sheets, published magazines and national accounts by Central Bank of the Islamic Republic of Iran during ( ). For exchange rate, the International Financial Statistics (IFS, different years) are used. The data used in this paper include the following: LCPI: logarithm of the consumer price index, LGDP: logarithm of real GDP (billion Rials), LM2: money supply and LEXR: the real effective exchange rate. The correct explanation of VAR model needs to test the time series data properties. When the rate of variables is nonstationary or has a unit root, the conventional econometric techniques may not be appropriate (Engle & Granger, 1987 and Enders, 1995). The investigation of stationary of variables showed that all variables are in nonstationary levels. Following once differentiation of the logarithm of these variables, all variables become stationary. The results of unit root test are presented in Table 1 and Table 2. Therefore, it can be concluded that the variables are first-order cumulative variables Analysis of Long-term Relationships To assess long-term relationships between variables, a non-binding VAR model is estimated. Of course, ρ: the number of intervals or the order of VAR must be determined. In this case, Akaike criterion is used. According to the Akaike optimum interval length criterion, 3 intervals have been selected and reported in Table 3. However, because the accumulation test is performed on the variables differences, the number of optimum intervals is equal to 2. After estimating the VAR, diagnostic tests including homogeneity variance, autocorrelation and normality of residuals were performed on the residuals. Then, accumulation test was carried out to determine the accumulation order. Table 4 represents the results of Johansson s accumulation test. Since the variables of model are nonstationary with unit roots, the option 3 is used for accumulation test. Both trace and maximum eignvalue statistics show that there is only one long-term relationship between the variables. Table 5 represents the accumulated vector. Long-term relationship can be written as follows: COPY RIGHT 2012 Institute of Interdisciplinary Business Research 1099

4 Table 5: Estimation of accumulation relationship consistent with economic theories Value of the t statistic T score Standard deviation coefficient variable LGDP(-1) LM2(-1) LCPI(-1) LEXR(-1) C According to this relationship, the effect on money supply on real GDP is negative. Moreover, the effect of consumer price index on GDP is positive. Also, the real effective exchange rate has a negative effect on real GDP. 1-2 Short-term Analysis In this section, more exact studies have been done to reveal the effect of real effective exchange rate fluctuations on real GDP, inflation and money supply. The effect of long-term relationships or accumulated vectors on short-term dynamics is examined by adjustment coefficient. Table 6 shows the results of vector error correction model (VECM). Table 6: Error Correction Model D(LEXR) D(LCPI) D(LM2) D(LGDP) Error Correction: ECM C According to the results of Table 6, it can be expressed that adjustment to the long-term equilibrium value for a real variable occurs in a short time. In addition, the adjustment to the long-term equilibrium value for CPI occurs in a longer time period. Also, adjustment to long-term equilibrium value for real effective exchange rate occurs in longer time period. Now, according to the VECM model, the relationships between variables are studied using Granger causality test, impulse response functions, and variance decomposition Granger Causality Between Variables Following estimating the model, the causal relationship between the variables of the model was examined using Granger causality test. The obtained results show that there is a weak Granger causality at confidence level of the 95% from the real effective exchange rate series toward consumer price index (CPI) and money supply. But, there is a one-way relationship from real GDP toward real effective exchange rate. On the other hand, the response of the logarithm of real GDP and the logarithm of price level from the logarithm of the real effective exchange rate toward a shock standard deviation is negligible. Only the logarithm of the money supply partly responds to it. This supports the results of Granger causality test. COPY RIGHT 2012 Institute of Interdisciplinary Business Research 1100

5 1-4 - Impulse Response Functions Impulse response functions are useful tools for examining the effect of unforeseen shocks of different variables on each other in a stable VAR models. In fact, using this method, the effect of exchange rate shocks on GDP, consumer price index (CPI) and money supply will be examined. The results show that the exchange rate shock reduces real GDP and money supply. In regard to price level, the exchange rate shock has a positive impact on it in the first period, but its effect has become negative, finally. At first, the exchange rate shock has a large positive impact on itself. However, this effect reduces over time. Table 7 shows the results of this test Forecast Error Variance Decomposition Another tool that can be used for better examining the relationships between variables of a system is forecast error variance decomposition. This tool will simply explain that the movement of a variable over time to what extent is due to the shocks of the variable and to what extent is due to the shocks caused by other variables of model. For example, in the case of variables investigated in this paper, the strength of exchange rate for predicting other variables of the model will be examined using the forecast error variance decomposition. The variance decomposition of the logarithm of real GDP shows that the major changes in this variable is derived from itself. In the case of money supply, firstly, much of the variation is explained by itself, but in later periods a significant part of changes is explained by the real effective exchange rate. In regard to changes in the consumer price index for goods and services, the high volume of change is explained by itself. Among other variables, the share of real GDP is significant in its changes. The results have been reported in Table 8. Generally, the results of this section are also partly consistent with the results of previous sections, especially the role of exchange rate have significantly appeared in the changes of money supply Decomposition of Exchange Rate Shocks and its Effect on Macro-Economic Variables To better assess the impact of exchange rate on macro-economic variables, the exchange rate shocks are separated from their trend using Hodrick - Prescott method. Then, as in part 1, by designing a VAR and VECM models, the effect of exchange rate shocks is studied using the response functions and forecast error variance decomposition methods. Therefore, the time trend of real effective exchange rate or HpLEXR is extracted using Hodrick- Prescott filter. The unanticipated shocks of exchange rate obtain by subtracting real effective exchange rate and anticipated shocks of exchange rate: The new series of LEXRSHOCK is added to the VAR model instead of the real exchange rate. The real effective rate shock series is also nonstationary. It becomes stationary after once differentiation. The results are reported in Table 9. In this section, as Part 1, a VAR model was developed to determine the optimum interval, and then the long-term relationship between the model variables is explored. Again, the optimum interval of 3 obtained according to Akaike statistic. Therefore, the Johansen s accumulation test is performed with two interruptions. The results of Johnson s accumulation test based on trace and maximum eignvalue shows that there is only one long-term relationship between the variables. The estimated error correction model (VECM) is also indicated that the real GDP is the Granger causality of the real effective exchange rate shock and the reverse is true. There is a weak Granger relationship from real effective exchange rate toward the price level and the money supply. The Responses of real GDP and the price level toward a standard deviation of the real effective exchange rate shock is negligible. In the case of money supply, the response is somewhat greater and the real effective exchange rate shock will explain slight percent of real GDP and price level. But, in regard to money supply, this value is significant compared to two variables. COPY RIGHT 2012 Institute of Interdisciplinary Business Research 1101

6 Therefore, it can be concluded that, the results of this section are consistent with the results of the first part. Conclusions and Recommendations The present study examined the effect of real effective exchange rate fluctuations on macro-economic indicators (real GDP, inflation and money supply). For this purpose, the Vector Autoregression method was used for time-series data during The results of trace and maximum eigenvalue test show an accumulated relationship between real GDP, price level, money supply and real effective exchange rate. Estimated long-term relationship indicated a negative relationship between money supply and real GDP. Moreover, long-term relationships show a positive relationship between the consumer price index (CPI) and real GDP. Also, the long-term relationships show a negative relationship between the real effective exchange rate and real GDP. Following estimating long-run relationships using vector error correction model, the short-term relationships between variables was analyzed. In these models, the adjustment coefficient is small. This shows that the adjustment towards long-term equilibrium occurs over a longer time. The results of Granger causality test show that there is a weak Granger causality at confidence level of 95% from the real effective exchange rate series toward consumer price index (CPI) and money supply. But, there is a one-way relationship from real GDP toward real effective exchange rate. On the other hand, the reaction of the logarithm of real GDP and the logarithm of price level toward a shock standard deviation is negligible from the logarithm of the real effective exchange rate. Only the logarithm of the money supply partly responds to it. This supports the results of Granger causality test. The results of impulse function response show that the exchange rate shock reduces real GDP and money supply. In regard to price level, the exchange rate shock has a positive impact on it in the first period, but its effect has become negative, finally. At first, the exchange rate shock has a large positive impact on itself. However, this effect reduces over time. Generally, impulse response functions partially confirm the previous results (regardless of the Hodrick Prescott method), because this variable did not have much effect on GDP (this variable was not the Granger causality of production) and it shows a greater impact on the price level (the Granger causality of price level) and the money supply (Granger causality with low probability). The results of forecast error variance decomposition showed that the logarithm of real effective exchange rate explains a few percent of the forecast error variance of production and the logarithm of the consumer price index. However, in the case of the logarithm of the money supply, the issue is a somewhat different and the logarithm of real effective exchange rate explains a significant percentage of its changes. This again supports the results obtained in previous sections. In the second part, the real effective exchange rate was decomposed to trends and shocks. The obtained results are similar to the results of the first part. The real GDP is the Granger causality of real effective exchange rate, but the reverse is not true. There is a weak Granger relationship from the real effective exchange rate toward the price level and the money supply. The response of real GDP and the price level toward a standard deviation of the real effective exchange rate shock is negligible. However, in the case of money supply the response is somewhat greater and the real effective exchange rate shock explains a few percent of real GDP and price level. In the case of money supply, this percentage is still significant compared to other two variables. Therefore, it can be concluded that the results are consistent with the results of the first part. Generally, regardless of decomposition of real effective exchange rate, similar results will be obtained about its impact on macro-economic variables and the results are consistent with each other. COPY RIGHT 2012 Institute of Interdisciplinary Business Research 1102

7 References Oladi, R., H. Beladi, and N. Chau (2008), Multinational corporations and export quality, Journal of Economic Behavior & Organization, Vol. 65, No. 1, pp Kazerooni, A.R., Rostami, N, 2007."The Study of Asymmetric Effects of Currency rate Fluctuation on Actual Production and Price in Iran", economic research press, 9, PP COPY RIGHT 2012 Institute of Interdisciplinary Business Research 1103