Impact of exchange rate volatility on macroeconomic variables

INTRODUCTION

1.1 Introduction

“Exchange rate” is the price of one currency in relation to another. In a slightly different perspective, it expresses the national currency’s equation to foreign ones. Thus, exchange rate is a conversion factor, a multiplier or a ratio, depending on the direction of conversion. It is believed that if exchange rates can freely move, it may turn out to be the fastest moving price in the economy, bringing together all the foreign goods with it.

Volatility is defined as “instability, fickleness or uncertainty” and is a measure of risk, whether in asset pricing, portfolio optimization, option pricing, or risk management, and presents a careful example of risk measurement, which could be the input to a variety of economic decisions.

Volatility of exchange rates describes uncertainty in international transactions both in goods and in financial assets. Exchange rates are modeled as forward-looking relative asset prices that reflect unanticipated change in relative demand and supply of domestic and foreign currencies, so exchange rate volatility reflects agents’ expectations of changes in determinants of money supplies, interest rates rates and incomes.

As many developing countries have or considering implementing changes in their development strategies, now is an opportune time to investigate the issue of whether alteration in exchange rate arrangement have an effect on economic growth or to what extent exchange rate volatility may be the responsible for variation in the rate of economic production. Because such moves are accompanied by increase in the volatility of both, nominal and real exchange rates [Caporale and Pittis 1995]. Real exchange rate uncertainty can have negative effects on both domestic and foreign investment decisions. It causes reallocation of resources among the sectors and countries, between exports and imports and creates an uncertain environment for investment.

Two branches of macroeconomic theory relate to the question of how exchange rate volatility affects macroeconomic performance.

i) The first examines how the domestic economy responds to foreign and domestic real and monetary shocks under different exchange rate regimes.

ii) The second focuses on the issue of how exchange rate volatility under flexible exchange rate regimes affects international trade.

In the case of free mobility of capital, an economy that is affected mainly by shocks to the LM curve, due to changes in money demand for example, will experience large fluctuations in output, inflation, and the exchange rate if the exchange rate is flexible.

If the exchange rate is fixed and capital is internationally mobile then the money supply is endogenous-changes in money demand determine changes in the money supply so that LM shocks will have no effect on output or inflation. Some recent work has certainly suggested that developing countries that peg their exchange rates achieve lower inflation than those whose exchange rate floats, [Ghosh et al. 1995, Aghevli et al. 1991, Obstfeld 1995, Alogoshoufis 1992, Collins 1996, Bleaney and Feilding 1999].

i) The most important reasons for a devaluation to trigger an aggregate demand contraction include: a redistribution of income towards those with high marginal propensity to save, a fall in investment, an increased debt burden, reduction in real wealth, a low government marginal propensity to spend out of tax revenue, real income declines under an initial trade deficit, increased interest rates, and increased foreign profits [Diaz-Alejandro 1963, Cooper 1971a, 1971b, 1971c, Krugman and Taylor 1978, Branson 1986, Buffie 1986b, van Wijnbergen 1986, Gylfason and Risager 1984, Gylfason and Schmid 1983, Hanson 1983, Gylfason, Radetzki 1991, Barbone and Rivera-Batiz 1987].

ii) On the other hand, aggregate supply may suffer after devaluation because of more expensive imported production imputs, wage indexation programs, costlier working capital [Bruno 1979, gylfason and Schmid 1983, Hanson 1983, Gylfason and Risager 1984, Islam 1984, Gylfason and Radetzki 1985, Branson 1986, Wijnbergen 1986 and Edwards 1989b].

iii) Increases in the volatility of the real effective exchange rate exert a significant negative effect upon export demand in both the short-run and the long run and these effects may result in significant reallocation of resources by market participants. The issue is particularly important for countries that Switched from a fixed to a flexible exchange rate regime due to the higher degree of variability associated with flexible exchange rates [Hooper and Kohlhagen 1978, Coes 1981, De Grauwe 1988, Brada and Mendez 1988, Caballero and Corbo 1989, Cote 1994, Baum et al 2001, and Arize, Osange, and Slottje 2004].

iv) The impact of exchange rate volatility on investment and hence on economic growth is not a recent source of concern. It is noted in the literature that uncertainty reduces investment in the presence of adjustment costs and when the investment process includes irreversibility’s. Real exchange rate uncertainty creates an uncertain environment for investment decisions and therefore, investors delay their investment decisions to obtain more information about the real exchange rates if investments are irreversible and exerts negatively on economic performance. Campa and Goldberg 1993 found a negative impact of exchange rate volatility on investment.

Whereas Aizenman [1992] found positive relationship. While Campa & Goldberg (1995) found almost no impact.

Instability in exchange rate can influence loner-term decisions by affecting the volume of exports and imports, the allocation of investment and government sales and procurement policies. In medium term, it can affect the balance of payments and the level of economic activity, while in the short run local consumers and the local trader can be affected.

Exchange rate volatility gives chances to investors to invest in foreign currency (dollars) to get higher returns and thus resulting in the strengthening the dollar against the home currency, which directly impacts the prices of exports and imports and their growth rates. Risk averter traders and investors always favour the system where the variance of the difference between actual and expected value of exchange rate is minimized, while risk lover traders and investors prefer volatile exchange rate so that they can maximize their profits because of high risk premium. Therefore, exchange rate volatility can have positive impact on exports and negative on imports for risk lover traders and vice versa for risk averter traders.

Hooper and Kohlhagen (1978) found negative association between exchange rate instability and volume of trade but found positive association with export prices when exporters bear the exchange risk and negative impact when impoters bear the risk. Lanyi and Suss (1986) argues that exchange rate variability affects domestic currency and prices of exports and imports, which hinders the international transactions.

It is often taken for granted that an increase in the risk leads risk averter individuals to shift towards least risky endeavors. This popular view has led many to conclude that exchange rate volatility in principle should have negative impact on trade by increasing the risk of international trade activities [De Grauwe (1988) ]. The risk averters worry about the worst possible outcomes, and increase exports to avoid the possibility of drastic decline in their revenues. However, less risk averse or risk neutral persons are less concerned with extreme outcomes.

Keeping such relationships in mind a hypothesis is developed relating to the link between exchange rate volatility and macro economic growth. It is considered an opportune time for such analysis because more and more countries are considering revisions in their exchange rate arrangements. Theory suggests a direct link between exchange rate volatility and macro economic performance in the presence of open economies. In such state of affairs, the aim of this study is to find out the nature of this relationship, i.e. positive or negative or even insignificant.

1.2 Objectives of the Study

Following are the objectives of present study:

i) To identify exchange rate as one of the most important macroeconomic variables of the economy.

ii) To know about the importance of real exchange rate for domestic & foreign investment.

iii) To analyze the macroeconomic variables which are effected by exchange rate variation.

iv) To study the monetary policy and its effect as corner stone of the modern economy.

v) To assess the importance of exchange rate volatility in effecting the trade & economic growth of the country.

vi) To suggest possible remedial measures to stabilize the exchange rate in Pakistan.

1.3 Material & Methods

The data used in this study is collected from the secondary sources. The time series data to analyze the impact of exchange rate volatility on macroeconomic variables in Pakistan is covering the span of 1975 to 2005. An econometric analysis based on time series techniques is used to analyze the trends and patterns of exchange rate volatility and its impact on macroeconomic variables in Pakistan. Volatility of real exchange rate will be taken as exogenous variables while real exports of Pakistan, GDP, manufacturing products, foreign exchange reserves, foreign direct investment and trade openness will be taken as endogenous variables. only those endogenous variables are selected for this study whose data were available from the various published sources.

1.4 Organization of the Study

This study has been organized into six chapters as follows:

Chapter 1 gives brief introduction of the topic. Chapter 2 provides a profile of exchange rate and macroeconomic variables in Pakistan. It covers the detail description of all the selected macroeconomic variables affected by exchange rate volatility. Chapter 3 encompasses the survey of the international and national literature regarding the topic of this study. The literature selected for this study starts from 1975 to 2005. Chapter 4 takes into account the selection of data and methodology employed for this study. Chapter 5 covers the empirical analysis of the data along with results of estimation techniques used in this study. Chapter 6 finally concludes the results.