Why is it apparently so difficult to forecast exchange rate movements? Discuss with reference to the monetary model, the Mundell-Fleming model and/or the Dornbusch model and its extensions
Abstract
A country’s exchange rate is largely influenced by the demand of money or the country’s currency which is also determined by the interest rates existing in the country at a particular time (McConnell & Brue, 1990). The interest rates are manipulated or influenced by a country’s central bank open market operations (Blanchard, 2006). However, there is little evidence that suggests that economic variable can be utilized to predict the exchange rate in an economy even in countries that have similar inflation rates at least in the short run (Wang, 2008, p.1).
Introduction
Robert Mundell and Marcus Fleming developed the Mundell-Fleming model that describes the short-run relationship that exists between a country’s exchange rate, output and interest rates in an open economy while also contrasting it to the IS-LM model which is closed economy model that restricts its comparisons to interest rates in an economy and the output produced (Mankiw, 2007)
The Mundell –Fleming economic model is based on the equation below; The IS Curve,
Y= C + I + G + NX where NX is the net exports, C, is Consumption, I, is physical investments and G is Government spending which is an exogenous variable while the LM curve is represented by frac {M} {P} = L (I, Y) (Young & Darity, 2004). High interest rates or low GDP that has been caused by low incomes ultimately leads to reduced demand for money (Mundell, 1963).
The Mundell –Fleming economic model is also referred to as the IS-LM-BoP model. It’s basically an extension of the closed model IS-LM. The Mundell –Fleming economic model argues that a country’s economy cannot maintain an independent monetary policy, free capital movement and also a fixed exchange rate system, a concept mostly known as the inconsistent trinity or the Mundell-Fleming trilemma (Fleming, 1962).
The models application can be explained using the IS-LM-BoP graph that applies the use of domestic interest rates that have been vertically plotted against the GDP. The LM curve slopes upward while the IS curve slopes downwards just like in a typical closed economy IS-LM evaluation analysis where unless there is absolutely perfect capital mobility, the BoP curve slopes upward and it remains horizontal where the world interest rates applies. Under a regime that applies the flexible rate, the exchange rate is allowed to operate freely and it’s determined by the operations of the market forces alone (DeGrauwe, 2000). When the money supplies increases the LM curve is shifted towards the right which results in reduction of a country’s interest rates compared to global interest rates. When there is a reduction of the supply of money in an economy then the exact opposite happens.
IS-LM-BoP Graph
I IS 1 LM
IS LM 1
I FE (BoP)
Y
When there is an increment in government expenditure, the IS curve shifts to the right and it causes a country’s interest rates together with its GDP or income to increase while a decrease of the expenditure by the government reverses the whole process (Engel & West, 2005, p. 486).
When the global interest rates raises the BoP curve shifts upwards and results in capital outflows from the local economy. This action depreciates the country’s currency which boosts the net exports as it makes the local currency cheaper compared with the other international currencies, an action that causes the IS curve to shift to the right. When the capital mobility is less than perfect, the exchange rate that has been depreciated causes the BoP curve to shift back down. Under normal and perfect mobility, the BoP curve remains horizontal at the same level with the world’s interest rates. When the latter increases, the BoP is shifted upwards by the same margin and it remains there while the exchange rate makes enough changes to shift the IS curve to cross the BoP curve at the intersection with the LM curve that has not changed and where the local interest rates also equals the world’s interest rates. The same case happens when the interest rates decrease only that it reverses the actions (Carlin & Soskice, 1990).
Under fixed rate, the exchange rate is fixed by a country’s central bank which announces the rate that they are willing or prepared to sell or buy the domestic currency. Hence the net payments in or outflows need not equal to zero in a country as the rate of exchange, e is mostly exogenously provided while the BoP variable is endogenous.
A country’s central bank, under the fixed exchange rate regime, plays a crucial role of determining the economy’s exchange rate by operating in the international foreign exchange market in order to maintain a particular or specific exchange rate. In case of pressure to depreciate or reduce the value of the local currency exchange rate when the supply of local currency surpasses its demand in the foreign market then regime’s central bank purchases the local currency with the international currencies to reduce the supply of the local currency in the foreign exchange market to maintain the required rate of exchange.
Rudiger Dornbusch’s model on exchange rate stem from his paper on Expectations and Exchange rate dynamics that caught the world’s attention in international economics and its outstanding effect in macroeconomics. Dornbusch’s (1976) reformulation of the Mundell-Fleming model with his rational expectations on floating exchange rates has inspired fresh thinking and new discussions. The model has been applied to a host of other situations besides on the exchange rate platform others include Commodity price volatility and to disinflation analysis on developing countries. Friedman’s (1953) positive concept on flexible exchange rates turned out negatively infact the exchange rates were exhibited a more volatile reaction that was unexpected from even the experts. However, Dornbusch laid out an incredible simple explanation that indicated, using sticky price how the instability in monetary policies led to the unstable exchange rates in mid-1970. His theory on overshooting shocked and also delighted the researchers because he proved that the process of overshooting originated elsewhere and did not grow from myopia hence its behavioral trends could be traced in the same markets. However, the exchange rate volatility was actually required to temporarily equilibrate and balance the financial system in view of monetary shocks as the underlying prices take time to adjust.
According to Wang (2008) the US has been losing value over the last several years. Between the years 2001 and 2002, the American dollar ($) lost more than 40% of its value against the Canadian dollar, 30% against the British Pound and 50% against the Euro. These depreciations have put a lot of pressure on the urgency to understand the nature of factors that influence the exchange rate. Understanding the exchange rates would allow better and well informed decision to be made. Unfortunately it’s almost impossible to predict the exchange rate movements not even over short duration. However, trade balances, money growth and national income have very strong influence on the exchange rates (Wang, 2008, p.1)
Source: (Economic research, n.d)
It may seem logical that a country with very large trade deficits would certainly have their currencies decline in value as countries with very strong growth potentials and low inflation rates see their currencies appreciate in value. But these logics are very hard to prove. In the year 1983, two economists Kenneth Rogoff and Richard Meese decided to put to test the long held theory that economic fundamentals can influence or determine the relative values of currencies (Rossi, 2005, p.80) The economist utilized the existing models to compare against alternatives and where economic fundamentals were excluded while any changes in exchange rates were purely random (Kilian & Taylor, 2003, p.70). The economists concluded that economic fundamentals, just like the trade balances, national income, money supply or other variables were actually of very little use when forecasting the exchange rates in countries that have similar rates of inflation. The results were referred to as the “exchange rate disconnect puzzle “(Wang, 2008, p.2).
The exchange rates are also very volatile compared to economic fundamentals that are supposed to determine them. In a span of 30 years, for instance, the changes in exchange rates between the UK pound and the US dollar were wider than the actual differences between the country’s output and inflation (Wang, 2008, p.3).
Wang (2008) confirmed that:
The high volatility of exchange rate relative to economic fundamentals is very difficult to replicate in a model without introducing arbitrary disturbances. The fact that standard, fundamentals-based models can’t outperform a random walk casts serious doubt on their ability to explain exchange rate fluctuations. The random walk itself does a mediocre job predicting exchange rate movements
(p.4)
However, under several combinations of some variables and econometric concepts in an effort to predict exchange rates, some models have not entirely disapproved the disconnect concept but have instead discovered that some evidence exists that indicate that under certain conditions some economic fundamentals matter. For instance, under longer time frames predictability improves in models with standard exchange rate. With longer time frames, economic fundamentals can do better than random walk when predicting the long- term changes in foreign exchange rates (Wang, 2008, p.6).
Finally, the introduction of a monetary policy feedback on economic fundamentals and exchange rate comparisons over long periods can improve real predictability. Evidence suggests that the random walk that is used in forecasting the exchange rates can be outperformed by the models that may incorporate the actions of the local regimes central bank operations (Engel & West, 2005, p. 486). Also the overshooting was infact at one point a necessity when the exchange rate volatility was actually required to temporarily equilibrate and balance the financial system in view of monetary shocks as the underlying prices take time to adjust on the Rudiger Dornbusch’s model on exchange rate. Hence during the long term some economic fundamentals can be utilized to predict the exchange when comparing countries with equal inflation rates.
References
Blanchard, O., 2006, Macroeconomics (4th ed.), Upper Saddle River, NJ: Prentice Hall,
Carlin, W. & Soskice, D. W., 1990, Macroeconomics and the Wage Bargain, New York: Oxford University Press,
DeGrauwe, P., 2000, Economics of Monetary Union (4th ed.), New York: Oxford University Press,
Dornbusch, R., 1976, “Exchange Rate Expectations and Monetary Policy”. Journal of International Economics 6 (3): 231–244.
Economic Research, n.d, Federal Reserve Bank of ST. Louis, viewed 23 March 2015
Engel, C. and West, K.D., 2005, Exchange Rates and Fundamentals,” by Journal of Political Economy, vol. 113, June, p. 485–517.
Fleming, J. M., 1962, Domestic financial policies under fixed and floating exchange rates. IMF Staff Papers 9: 369–379. Reprinted in Cooper, Richard N., ed. (1969). International Finance. New York: Penguin Books.
Fried, M. (1953) “The Case For Flexible Exchange Rates” Essays in Positive Economy, p. 157-203, Chicago; University Of Chicago press.
Kilian, L & Taylor, M.P., 2003, Why is it so Difficult to Beat the Random walk Forecast of Exchange Rates? Journal of International Economics, Vol 60, May, p. 58 – 107
Mankiw, N. G., 2007, Macroeconomics (6th ed.), New York: Worth,
McConnell, C. R. & Brue, S. L., 1990, Economics: Principles, Problems, and Policies (11th ed.). New York: McGraw-Hill.
Mundell, R. A., 1963, “Capital mobility and stabilization policy under fixed and flexible exchange rates”. Canadian Journal of Economic and Political Science 29 (4): 475–485. Reprinted in Mundell, Robert A. (1968). International Economics. New York: Macmillan.
Rossi, B., 2005, Testing Long-Horizon Predictive Ability with High Persistence, and the Meese-Rogoff Puzzle, Economic Review, Vol 46, February 2005, p. 61-92.
Wang, J., 2008, Why are Exchange Rates so Difficult to Predict, Economic Letter, Vol 3, No.6 June 2008.
Young, W. & Darity, W. Jr., 2004, “IS-LM-BP: An Inquest”, History of Political Economy 36 (Suppl 1): 127–164
