Econometric Model of echange rate determinants

Abstract

Exchange rate fluctuations are an important risk for any country’s market and other economic instruments. It not only affects the individual firms to set the prices but also affects the country’s overall demand. The exchange rate volatility affects a firm’s bottom line and the financial performance of the firm. According to Huber (2016), “Forecasting exchange rates has been one of the major challenges in the field of economics since the early eighties”. However, it is acknowledged that exchange rate fluctuations affect firms due to its sensitivity related to other global factors. Therefore, understanding this behavior is critical for economic markets as well as the formulating future policy models. Thus, with this context, the report presents the rationale, theoretical framework, definitions, observations and assumptions of modeling the exchange rate for developing countries like India and Indonesia. We start with deriving a theoretical model based on sticky price formulation (Frankel 1984). But a major restriction to developing a free macroeconomic model is the managed exchange rate regime that is followed in most developing countries. Therefore we control for it and develop an augmented sticky price model. This model is tested with an empirical analysis, through a regression of Rupee/Dollar and Rupiah/Dollar exchange rates with the variables of the augmented sticky price model. Later we come to the conclusion that the coefficients of money supply (+ve), interest rate (-ve), inflation (+ve), gdp growth (-ve), trade balance (-ve) and forex reserves (-ve), that we get from regressing our empirical equation are well grounded in macroeconomic theory. Further we also compare the difference between magnitudes of these coefficients for India and Indonesia, and present conjectures based on broad macroeconomic understandings of the two economies to explain these differences.