Interest rate and exchange rate policies Assignment

Interest rate and exchange rate policies Assignment Words: 1998

The results of Granger causality test evidence bidirectional relationship between interest rates and exchange rates. The results show that there is substantial lead lag relationship of interest rates to exchange rates. We found the same relationship of the exchange rate to the interest rate. These results are useful to investors and policy makers. In the point of view of investors, they can use this information history of interest rates and exchange rates to predict the movement of stock returns.

Similarly , policy makers can stabilize the volatility of the stock market by adopting appropriate policies towards interest rate and the exchange rate for time to time . The theoretical relationship between the interest rate and exchange rate policies has been a debatable issue among the economists. An increase in interest rate is necessary to stabilize the exchange rate depreciation and to curb the inflationary pressure according to Mendel-Fleming model. Therefore it helps to avoid many adverse economic consequences.

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There have some reasons why the high interest rate policy is considered important. First, it provides information to the market about the determination of the authorities did not allow sharp exchange rate movements as the market anticipates economic conditions and thereby reduce the range and prevent the vicious cycle of inflation and exchange rate depreciation. Second, it raises the attractiveness of financial assets in the state as a result of capital inflows occur and thus limit the depreciation of the exchange rate.

Third, it not only reduces the bevel of aggregate domestic demand but also improve the balance of payments by reducing the level of imports. The critics argue that the high interest rates endanger the ability of local firms and banks to repay foreign debt and thus reduce the probability of repayment. As a result, high interest rate will lead to capital outflows and depreciation of the currency. The currency of Australia is the Australian dollar (ADD). Exchange rate regime in Australia has grown from a regular regime of managed float through float freely. Australia maintained a fixed exchange rate Breton Woods period 1945 to 1973.

After the breakdown of the Breton Woods system in 1973 the system of fixed exchange Reserve Bank and is associated with a trade-weighted basket of currencies. In the year 1980, many capitalist countries are in the trend of their currency float. The reason might be that they are aware of the loss of independent control by the domestic monetary policy can lead to inflation and reductions in export competitiveness. In addition, the linked exchange rate may expose the country to speculative attacks. The currency of New Zealand is the New Zealand Dollar (NZ).

The Effective Rate was reared and link Pound Sterling has been replaced by a peg to the U. S. Dollar in year 1971. The New Zealand Dollar was placed on top where floating in a controlled basis in year 1973. The exchange rate is calculated from the New Zealand dollar which is determined on the basis of a fixed relationship with the New Zealand Dollar and a basket of currencies representing New Sealant’s major trading partners. Weight currencies included in the basket established their proportionate share of total receipts during the New Zealand and overseas payments where weights are adjusted quarterly.

A crawling-peg system of monthly depreciation adopted from year 1979. However, it is not possible to accept the change in interest rate policy to be purely external to stabilize the exchange rate as the monetary authorities in many countries to resort to high interest rate policy when the currency is under pressure and interest rate policy low when the currency is in sight. In other words, the decline in the exchange rate may also prompt monetary authorities to raise domestic interest rates. The objective of this paper is to ensure that the change in monetary policy is exogenous to the exchange rate.

Changes in monetary policy have substantially different effects on the exchange rate depending how they alter expectations regarding future policy. A greater understanding of the impact of interest rates on exchange rates is of interest. While it is possible to identify some of the determinants of the exchange rate, it is important to note that the effect may vary from time to time. In particular, while the terms of trade have shown a strong correlation with the exchange rate in the post- float, there is evidence to suggest that this relationship has weakened over the last 1 5 years.

Relationship is very weak in the late sass and early the sass when the terms of trade Australia has increased but the nominal and real exchange rates both declined significantly. Some part of this decline reflects the appreciation of the U. S. Dollar at the time, which in turn distributed to investors shift their portfolio towards investments in technology assets ‘new economy’ and away from the so-called ‘old economy’ assets prevalent in Australia. This paper is structured as follows. Firstly, we discusses about review of literature on discussed.

Next, we discuss the empirical findings result and lastly are the conclusions. LITERATURE REVIEW Before discussing the economic literature on the relationship between interest rates and exchange rates is full, it will be useful to briefly discuss some of the important theories of exchange rate determination. There are many theories such as the theory of Purchasing Power Purchase Agreement (APP), the Flexible Price Monetary Model (FMP), Sticky Price Monetary Model (SUM), Real Interest Rate Differential Model (RID), and Portfolio Balance Theory (PET) of exchange rate determination.

The APP to maintain equality between domestic and foreign prices are based on the domestic currency through commodity arbitrage. If the equilibrium is violated, the same commodity after exchange rate adjustment will be sold at different prices in different countries. As a result, commodity arbitrage or buy a commodity at the same time the lower price and sell at the higher prices will lead back to the equilibrium exchange rate. The FMP, SUM, and RID known as model monetarists exchange rate determination. Demand and supply of money is a major determinant of the exchange rate.

They also assume that domestic and foreign bonds are equally risky to their expected returns will be equalized which covered interest parity will prevail. Assuming wages in the labor market and commodity prices in the goods market to be perfectly flexible APP theory continued to hold and the expected return between domestic and foreign bonds with the same risk and the same maturity, FMP argue that the relative money supply, inflation expectations, and economic growth as the primary determinant of the exchange rate in the economy.

The SUM, which was first developed by Doorknobs (1976), argues that short-term prices and wages tend to be rigid, investors desire to equalize expected returns across countries is seen as a key determinant of short- ERM exchange rate, while the arbitrage market is seen as related items the determination of the exchange rate in the medium and long term. Franken (1979) developed a model of the exchange rate, known as model a real interest rate differential which combines the role of inflation expectations from FMP and sticky price Doorknobs model is the determination of the exchange rate.

According to the portfolio balance model, current account, risk factors and fiscal policy are the authorities intervene in the foreign exchange market is a key determinant of exchange rates (Brannon and Koori, 1976). Skinny and Schmeltzer (1998) studied the correlation between the time series of daily exchange rates and interest rates in Indonesia, Korea, Malaysia, Philippines, Thailand, and China using daily data during the second half of 1997. They found that the signs of this correlation are very unstable and concluded that interest rates in these countries should not be an exogenous variable. exchange rates for the countries of Asia in July 1997 and July 1998 by using the Vector Autoregressive (VARY) based on the impulse response function of the daily interest rate and the exchange rate. They did not find any firm conclusions about the relationship between interest rates and exchange rates. Some researchers have studied the relationship between interest rates and exchange rates in the wider international crisis. In this context, Goldman and Guppy (1999) examined 80 episodes of currency crises between 1980 and 1998.

By using a fixed-effects panel regression they concluded that the increase in interest rates related to the appreciation of the nominal exchange rate. They also found that the probability of choosing the high interest rate policy in the post-crisis period is low if he banking crisis. Kraal (1998) examine whether the increase in the policy interest rate can defend speculative attacks using monthly data for 75 developed and developing countries in the period 1060 to 1099 and found that the policy of high interest rates do not defend currencies against speculative attacks.

Then, he concludes that there is a lack attracts any systematic association between interest rates and the results of Farman and Stilling (1998) studied the effect of rising interest rates, inflation, and many non-financial factors to the exchange rate for the nine developing countries in 1992 to 1998. They found that the higher interest rates associated with a nominal depreciation of the exchange rate but the effect was more pronounced in low inflation countries than in high inflation countries.

THE DATA AND METHODOLOGY On the basis of a study of theoretical and empirical literature on the relationship between interest rate and exchange rate for the Australia and New Zealand Country, we hypothesize exchange rate as a function of interest rate. The rationale behind this hypothesis and a priori relationship between the exchange rate and other factors including interest rate can be expressed as follows here there are two views on the relationship between interest rates and exchange rates.

According to one view uncovered interest parity theory that implies that the domestic interest rate is the sum of the world interest rate and the expected depreciation of the home currency is the basis of determining the exchange rate. In other words, the interest rate differential between the domestic and world interest rate is equal to the expected change in the exchange fluctuation in exchange rates in the state. Therefore, the difference of higher interest can attract capital inflows and lead to educe the demand for money which leads to currency depreciation due to high inflation.

The second view has also been supported by Farman and Stilling (1998) argue that high interest rates endanger the ability of local firms and banks to repay foreign debt and thus reduce the probability of repayment. Therefore, high interest rates lead to capital outflows and depreciation of the currency.. The required data for the purpose of estimation have been obtained from the various publications of Reserve Bank of Australia and Switzerland also in the International Monetary Fund.

The study uses monthly for one time periods namely from January 1980 to July 2013 for monthly. The exchange rate is measured by the Australian Dollar and New Zealand Dollar in terms of USA dollar. The first step of econometric that has been used is to test the null hypothesis that the series are random walk or non-stationary by using Augmented Dickey-Fuller (1979) test. Augmented Dickey-Fuller (UDF) is measured by the following formula, where is the drift term, denotes the time trend, and is the largest lag length used.

We have tested the possibility of one or more co-integrating relationships using the Johannes and Julius (1990) methodology in the form of two test statistics namely, the trace test and the maximal Gene value if the variables were found to be non- stationary. Granger causality between interest rate and exchange rate and weak exigently of interest rate has also been studied. Johannes Congregation Test is measured by the following formula, where is a k-vector of variables, is a n-vector of deterministic trends, and is a vector of shocks.

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