Reinvestigating Sources of Movements in Real Exchange Rate

Abstract

In the last decade or so, important developments have taken place in economics of exchange rate, with substantial contributions to both theory and empirical understanding of exchange rate determination. But a number of challenges remain unresolved. With regard to the effect of economic policy on exchange rate, it is clarified that not only current policy actions but also the expectations concerning the future policy affect exchange rate. In this study we investigated the sources of movements in REER (Real Effective Exchange rate). For analysis of REER determination, we pooled the cross sectional information of five developing countries for the period 1975-2010. By application of Im, Pesaran and Shin unit root test, we confirmed the non-stationarity of pooled time series and cross-section data. After confirming non-stationary of data, we applied Pedroni’s panel co-integration test to test whether real exchange rate, in long run, significantly reacts to the changes in real variables or not. We considered terms of trade, government spending, productivity shocks, trade openness and capital inflows as the key determinants of REER. Pooled Least-Square method was applied to estimate the co-integrating coefficient. Our study results indicate REER appreciates in response to changes in terms of trade, productivity and capital flows. For government consumption spending results are mixed. Trade openness explicitly depreciates the REER. All the response parameters are significant. The results are consistent with the view that changes in real variables have a significant influence on variation in real exchange rate.

Key words: Exchange rate, Terms of Trade, Trade Openness, Financial Openness