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The purpose of this paper is to examine the effects of exchange rate shock on the broad spectrum of the US economy using a factor-augmented VAR model (FAVAR).
Abstract
Purpose
The purpose of this paper is to examine the effects of exchange rate shock on the broad spectrum of the US economy using a factor-augmented VAR model (FAVAR).
Design/methodology/approach
The authors developed a two-factor FAVAR model and estimated it with the single-step Bayesian likelihood approach using the Gibbs sampling technique. The two factors represented, respectively, the economic activity and price pressures. The exchange rate shock was identified with the Choleski decomposition method for VARs. The authors used the data of 117 time series for the period from 1973:02 to 2007:12. Impulse responses and variance decompositions were computed as the main results.
Findings
The authors found that exchange rate shock has pervasive effects on the US economy as the following: depreciation does not appear to help reduce the US trade deficit as both import and export rise with the depreciation shock; in the short run, depreciation appears expansionary as industrial production, manufacturing and employment all increase within a year; in the medium run, depreciation appears inflationary, as consumer price, producer price, import price and export price all increase; and in the medium run, depreciation appears contractionary as personal consumption, consumer confidence, stock price and housing start tend to fall.
Research limitations/implications
Some caveats remain: first, our simple model symmetrically estimates depreciation shock and appreciation shock and, hence, cannot draw inferences for how exchange rate appreciation and depreciation may affect the US economy asymmetrically. Second, the simple model used did not distinguish the different possible sources of exchange rate depreciation shock, the knowledge of which may lead to richer policy implications and is the direction of research for the future.
Originality/value
This research contributes to the literature of whether exchange rate is expansionary or contractionary to the US economy using the FAVAR model. This is the first comprehensive study in the literature studying the pervasive effects of the exchange rate on the broad spectrum of the US economy in one integrated model.
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Zekeriya Yildirim and Mehmet Ivrendi
Recent turbulence in global financial markets implies that emerging economies are likely to soon enter a new era with greater pressure for currency depreciation and capital…
Abstract
Purpose
Recent turbulence in global financial markets implies that emerging economies are likely to soon enter a new era with greater pressure for currency depreciation and capital outflows. This will likely bring challenges, including macroeconomic instability and inflationary pressures due to potential rapid depreciation. In this context, certain key questions about emerging economies have become focal points of discussion in political and academic spheres: what are the effects of exchange rate depreciation on economic activity? Does exchange rate depreciation create inflationary pressure? Finding answers to these questions is critical for policymakers and financial market participants. As such, the purpose of this paper is to shed light on these questions and thus provides guidance on mitigating the negative impacts of shocks in four fast-growing emerging economies.
Design/methodology/approach
The authors use a vector autoregression model with sign restrictions to examine the dynamic effects of exchange rate movements on fundamental macroeconomic indicators for four fast-growing countries, namely, Brazil, Turkey, Russia, and South Africa. Following Berument et al. (2012a), Ncube and Ndou (2013), Bjørnland and Halvorsen (2013), and An et al. (2014), the authors adopt the sign restriction methodology to identify exchange rate shocks alongside other macroeconomic shocks (monetary policy and productivity shocks) leading to exchange rate fluctuations.
Findings
The results show that exchange rate depreciation typically generates a deep recession and high inflation while improving the trade balance in the four emerging economies. This indicates that depreciation has strong “stagflationary” effects, which are transmitted to the macroeconomy primarily via supply-side channels, especially through the cost of import. Furthermore, the authors find that monetary policy reacts immediately to a domestic currency depreciation in all four emerging countries.
Practical implications
The results imply that these countries’ monetary policies are not and cannot be neutral to exchange rate shocks. However, in these import-dependent countries, monetary tightening (i.e. rate hikes in response to an exchange rate shock) plays a limited role in mitigating the negative effects of depreciation on inflation and economic activity due to the presence of a dominant supply-side channel. In this framework, policymakers should pay greater attention to structural reforms that aim to reduce import dependency. These reforms may increase the effectiveness of domestic monetary policy in mitigating the negative effects of external shocks.
Originality/value
This paper provides a useful perspective for policymakers designing economic interventions to mitigate the adverse effects of exchange rate depreciation and to those who borrow or lend in domestic or international financial markets.
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– This paper aims to investigate the impact of exchange rate depreciation and money growth to the consumer price index (CPI) inflation in Indonesia.
Abstract
Purpose
This paper aims to investigate the impact of exchange rate depreciation and money growth to the consumer price index (CPI) inflation in Indonesia.
Design/methodology/approach
Using threshold model applied to Phillips curve equation.
Findings
Using monthly data from 1980:1 to 2008:12, the econometric evidence shows that there are indeed threshold effects of money growth on inflation, but no threshold effect of exchange rate depreciation on inflation. Even though the threshold value for exchange rate depreciation is found at 8.4 percent, the F-test suggests that there is no significant difference between the coefficient below and that above the threshold value. While two threshold values are found for money growth, i.e. 7.1 and 9.8 percent, and they are statistically different. The impact on inflation is high when money grows by up to 7.1 percent, it is moderate when money grows by 7.1-9.8 percent, and it is low when money grows by above 9.8 percent.
Research limitations/implications
This research is using methodology proposed by Hansen which the threshold is based on the minimum SSR. The value of SSR will differ from one model to one model. For example, model using quarterly data will give the different result from that using monthly or yearly data. Also, when the author uses the new data, the result could be different.
Practical implications
Even though inflation targeting framework has been adopted by Bank Indonesia (BI) since 2005, BI should not disregard the monetary aggregate variable, especially M1. This is because the growth of money is still matter to influence inflation in the short run. The impact on inflation is found to be larger than the impact of exchange rate depreciation when it is below a certain threshold value.
Originality/value
This is the first paper that evaluates the threshold effect of exchange rate and money growth in emerging country, especially in Indonesia.
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To study the determinants and effects of “Operational” exchange rate exposure resulting from the mismatch between cost and revenues of the firms by using data on 500 Indian firms.
Abstract
Purpose
To study the determinants and effects of “Operational” exchange rate exposure resulting from the mismatch between cost and revenues of the firms by using data on 500 Indian firms.
Design/methodology/approach
We conduct detailed empirical analysis of the determinants of firm level exposure and their impact using panel regression techniques and conduct several robustness tests to confirm the validity of these results.
Findings
Among other factors, exchange rate volatility appears as a significant determinant of average firm level exposure with the direction of relationship supporting the presence of “Moral Hazard” in firm’s risk-taking behavior. Further large “operational” exposure is associated with significantly lower output growth, profitability, and capital expenditure during episodes of large currency depreciation at the firm level.
Research limitations/implications
This paper leaves several questions to be answered. Further research is called for to explore the nature of distortions in the production process encouraged by exchange rate volatility and their impact on firm level productivity. Looking at the relationship between the use of financial and operational hedges is another fruitful area of future research.
Practical implications
Our results have important implications for policy makers worried about mitigating the impact of exogenous shocks. Implicit and explicit guarantees with regards to the value of exchange rate tend to raise the vulnerability of the economy to exchange rate shocks at same time that they encourage capital expenditures and possibly output growth during “normal” times. Our findings indicate that the policy makers must take into account the incentive effects of their intervention in foreign exchange markets.
Originality/value
Unlike the existing papers in the literature, we use a measure of “operational” currency exposure based on foreign currency revenues and costs of firms. In most of the existing papers the focus is on the mismatch between the currency denomination of assets and liabilities. Little attention has been paid to the currency mismatch between costs and revenues of the firms. Such “operational” mismatches are potentially equally important and deserve attention of policy makers and academics alike.
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Muhammad Ali Nasir and Justine Simpson
The purpose of this paper is to analyse the implications of exchange rate depreciation for inflation targeting and trade balance of UK in the context of the Brexit epoch.
Abstract
Purpose
The purpose of this paper is to analyse the implications of exchange rate depreciation for inflation targeting and trade balance of UK in the context of the Brexit epoch.
Design/methodology/approach
The study employed a time-varying structural vector auto-regression (TVSVAR) model framework in which the sources of time variation were both the coefficients and variance-covariance matrix of the innovations on the data from January 1989 to September 2016.
Findings
The findings suggest that the depreciation of the Stirling has significant effects on inflation and trade balance in UK in context of Brexit epoch. It also showed that such a depreciation can be helpful in the improvement of external balance as well as steering the inflation to its statutory target. Despite, the inflation targeting, there is strong evidence of a pass-through.
Research limitations/implications
Research has profound implications in terms of the sharp depreciation of GBP associated with the Brexit outcome. The study is very topical and could be very interesting to the readership of JES as well as wider audience. The study has limitations in a context that the significance of the results and association of the under analysis entities is contingent on the future trade relationships and Channel between UK and EU. Therefore, although there is a lot of uncertainty about the future of Britain trade relationships, this study provides guidance on the importance of exchange rate channel if the similar trade arrangements prevails in the post-Brexit era.
Practical implications
The research has profound practical implications, using a TVSVAR model in which the relationship among the entities varies over time; it has shown the importance of exchange rate in terms of external balance and inflation targeting. Hence, it has appeal for the practitioners as well as academics.
Social implications
The research has great social implications. The Brexit is the biggest political and economic event of this era for UK and EU. There are big questions about the relationship between UK and EU in the post-Brexit epoch as well as questions about the future of the European integration. In this context, this study has shown that how the exchange rate could play an important role for the UK economy when its contemporary trade channels prevail. Concomitantly, it has social implications particularly for the European society.
Originality/value
The research is an original piece of work. It has contributed to the debate on the exchange rate deprecation, external balance and inflation targeting in context of the Brexit associated sharp depreciation of Stirling. It has used a framework, i.e. TVSVAR, which also have unique features in terms of testing the associations among under analysis entities against time.
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Ajaya Kumar Panda and Swagatika Nanda
The purpose of this paper is to examine the impact of changes in the exchange rate on long-term investment decisions of Indian manufacturing firms at the sector level.
Abstract
Purpose
The purpose of this paper is to examine the impact of changes in the exchange rate on long-term investment decisions of Indian manufacturing firms at the sector level.
Design/methodology/approach
The study is undertaken on a sample of 1,222 firms from six key manufacturing sectors of Indian economy during the period 2000-2016. The non-linear relationship between real exchange rate and long-term investment is studied using the two-step generalized model of moments estimator.
Findings
The study finds a concave (i.e. inverted U-shaped) relationship between the long-term investment and real exchange rate, particularly in case of chemical, construction, machinery and textile sector, in particular, and Indian manufacturing industry as a whole. It implies that investments in these sectors increase with depreciation of real exchange rate up to a point of inflection and subsequent to which it starts decreasing if exchange rate continues to depreciate further. But consumer goods and metal product sectors ensure a convex pattern, which demonstrates that investment is decreasing at the initial stage of depreciation of the exchange rate. The study moves one-step forward in validating this nexus between investment and exchange rate with respect to the price-cost margin and the extent of financial flexibility of firms. It is found that high price cost margin and financial flexibility moderates the adverse impact of exchange rate depreciation and immunizes the long-term investments in the scenario of a weak domestic currency and induce long-term investments.
Research limitations/implications
The study measures the impact of exchange rate changes, but the impact of exchange rate volatility on investment has not been studied, which is absolutely different with different implications.
Practical implications
The study provides a clear guideline to firm managers for using the exchange rate movements in a favorable manner. The findings can be used to ensure sustainable long-term investments with respect to the core competence of firms in terms of price cost margin and financial flexibility at sector level of Indian manufacturing firms.
Originality/value
The study analyzes the non-linear relationship between exchange rate changes and long-term investment behavior of manufacturing firms from six key sectors of India. Further, the study moves one step forward to analyze this nexus under different scenarios of financial flexibility and price cost margin using dynamic panel models.
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Zelealem Yiheyis and Jacob Musila
The purpose of this study is to examine the temporal relationships between inflation and exchange rate changes and their implications for the trade balance in Uganda, which saw…
Abstract
Purpose
The purpose of this study is to examine the temporal relationships between inflation and exchange rate changes and their implications for the trade balance in Uganda, which saw persistent trade deficits, rising inflation and disinflation episodes, as well as significant exchange-rate realignments and other liberalization measures over the sample period considered.
Design/methodology/approach
The short-run dynamics of the variables in question and the pattern of their long-run relationships are examined applying the bounds testing approach to cointegration on quarterly data.
Findings
The estimates suggest that, in the long run, a real depreciation leads to an increase in inflation; and that both real depreciation and inflation exert no significant effect on the trade balance. The estimated short-run dynamics suggest a causal relationship between the trade balance and the real exchange rate and between the real exchange rate and inflation, which is also found responsive to developments in the foreign sector. Taken together, the short-run and long-run multipliers seem to provide a weak support for the J-curve effect, while no evidence is found for the presence of the S-curve effect.
Originality/value
The study sheds light on the relationship among real exchange rate, inflation and the trade balance in the context of a small developing economy; it highlights that an improvement in the trade balance requires more than an appropriate exchange rate policy and underscores the importance of other policies in strengthening the external sector of the economy.
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Magda Kandil and Nazire Nergiz Dincer
The paper aims to examine the effects of exchange rate fluctuations on real output, the price level, and the real value of components of aggregate demand in Egypt and Turkey.
Abstract
Purpose
The paper aims to examine the effects of exchange rate fluctuations on real output, the price level, and the real value of components of aggregate demand in Egypt and Turkey.
Design/methodology/approach
Building on a theoretical model that decomposes movements in the exchange rate into anticipated and unanticipated components, the empirical investigation traces the effects through demand and supply channels.
Findings
In Turkey, anticipated exchange rate appreciation has significant adverse effects, contracting the growth of real output and the demand for investment and exports, while raising price inflation. Random fluctuations in Turkey have asymmetric effects that highlight the importance of unanticipated depreciation in shrinking output growth and the growth of private consumption and investment, despite an increase in export growth. In Egypt, anticipated exchange rate appreciation decreases export growth. Given asymmetry, the net effect of unanticipated exchange rate fluctuations, in Egypt, decreases real output and consumption growth and increases export growth, on average, over time.
Research limitations/implications
In light of the country‐specific evidence, future research should extend the investigation using panel estimation, incorporating various demand and supply shocks along with exchange rate fluctuations, to establish the relative importance of various shocks on macroeconomic performance across MENA countries.
Practical implications
While adhering to a flexible exchange rate policy to boost competitiveness, managing fundamentals to reduce excessive volatility impinging on the economic system over time should top the policy agenda.
Originality/value
Excessive volatility in the real effective exchange rate could be detrimental to real growth, over time, as the evidence for Turkey and Egypt illustrates.
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Lordina Amoah and Meshach Jesse Aziakpono
The purpose of this paper is to reexamine the speed and magnitude of exchange rate pass-through (ERPT) to consumer prices in Ghana.
Abstract
Purpose
The purpose of this paper is to reexamine the speed and magnitude of exchange rate pass-through (ERPT) to consumer prices in Ghana.
Design/methodology/approach
The Johansen Maximum Likelihood approach is employed in the estimation of different models of symmetric and asymmetric ERPT. Specifically asymmetric ERPT models with respect to the direction and size of exchange rate changes are estimated.
Findings
Results reveal that even though a depreciation in the nominal effective exchange rate will lead to an increase of consumer prices in the long-run, it is not statistically significant. Evidence also suggests a significant asymmetry with respect to direction and size of exchange rate changes. This indicates that the right ERPT model is an asymmetric model. Specifically ERPT is found to be incomplete but relatively higher in periods of depreciation than in periods of appreciation; that is 53 percent against 3 percent. ERPT is also higher during episodes of large changes (about 51 percent).
Research limitations/implications
It would have been interesting to analyze the impact on consumer prices through changes in import prices. That approach was not adopted due to lack of consistent data on import prices in Ghana.
Practical implications
It is imperative that the monetary authorities critically monitor exchange rate movements in order to be able to take swift policy action so as to counteract any inflationary pressures from the external sector. In particular, much attention should be paid to events and arrangements that could result in large depreciation of the exchange rate.
Originality/value
While previous studies have assumed a symmetric ERPT model for Ghana, this paper is unique in that it investigates the most appropriate model for examining ERPT in Ghana whether symmetric or an asymmetric.
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Yacine Hammami and Sabrine Kharrat
The purpose of the paper is to show that order flows determine exchange rate dynamics because they carry information about nonfundamental factors besides macroeconomic…
Abstract
Purpose
The purpose of the paper is to show that order flows determine exchange rate dynamics because they carry information about nonfundamental factors besides macroeconomic fundamentals.
Design/methodology/approach
To understand the role of nonfundamental factors in driving order flows, this study uses two approaches. Initially, Evans and Rime (2016) VAR framework is followed to study the incremental information transmitted by order flow compared to macroeconomic variables. Then, the study uses the settings in which Rime et al. (2010) conduct their empirical work, which gives the researcher more latitude in specifying the identity of the factors that drive order flows.
Findings
The findings evidence that order flows explain the dynamics of the TND/USD exchange rate. The results highlight that order flows convey information about technical strategies, the currency systematic factors and political risk. This study also documents the presence of a Ramadan effect in exchange rates and order flows.
Originality/value
This study makes four contributions to the literature. First, it complements the literature on the FX microstructure of emerging markets. The study investigates the information content carried by order flows, while the previous literature has focused solely on examining the explanatory power of order flows to explain exchange rates in emerging countries. The second contribution is that the study demonstrates formally that order flows determine exchange rates because they transmit information about nonfundamental factors. Third, this study is the first to examine whether order flows convey information about technical analysis. Four, the study relates order flow to nontraditional factors that are relevant to the Tunisian FX market.
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