FINANCE INDIA Vol, VIII No. 2, June 1994 Pages—357-364 Exchange Rate Dynamics : Further Empirical Evidence* SUKUMAR NANDI™ ABSTRACT ‘The theoretical framework of Dombusch explains the short nun volatility of the exchange rate, By incorporating long run Purchasing Power Parity condition Driskill has tried to explain the “overshooting” of the exchange rate ‘along with the long-run purchasing power parity constraint. This paper uses is model to test the same in the case of six countries over a larger period of time, In Section l,the derivation of Driskill equation is briefly discussed. The ‘methodology and the data are discussed in section 2 and the empirical results are presented in Section 3. The last section comes, in the forma of a conclusion. ————— Introduction : A LARGE SECTION of recent literature on flexible exchange rate has identified relative money supplies as the basic determinant of exchange rates and relative price levels in the broad monetarist tradition (Mcdonald, 1988; Barr, 1989; Dornbusch, 1976, 1979; Dornbusch and Frankel, 1988; Diskill, 1981; Mussa, 1976; Wallace, 1979). This literature, on the onc hand, is in broad agreement about the long run relationship between money, exchange rate, and the price level, it differs in its predictions about the short run. > exchange rate determination, on the other. Regarding the study on short run behaviour the literature reveals three distinct approaches. First, the Equilibrium Rational Expectation (ERE) version (Mussa, 1976) argues that the failure of the purchasing power parity condition can be explained by the fact that published price indices are poor indicator, of transaction prices and so these are inappropriate deflators of nominal money balances. This is an index number problem and price indices of different countries are based on different commodity weights. Second, the Currency Substitution (CS) models emphasis that real money balances as an aggregate may be held in a portfolio of currencies, so that the theory of exchange rate is a problem of portfolio selection (Calve and Rodriguez, * Financial grant of National Institute of Bank Management is acknowledged. Sunandita Debroy has provided research assistance. The usual caveat applies regarding the error, if any. ‘++ Associate Professor National Institute of Bank Management, NIBM, Pune-411048, India, Submitted June 1993, Accepted December 1993358 Finance India and the interest rate dif ions Is determine the short run exchange rate fl Thr, te Dorsbusch _ Tit de Doebch mol scm te soy sing commodin Inds ae the appopiae defan for sna mony lars sch, 1978). Whom pie are fed ne srs supply should induce a this raul dong a he Sepesit much ove han de foward Fei hat the soe peat ort run. In the exchange rate may Yong run equilibrium + price trade-halance effects I changes the Dorabuseh 3 twtr equton for estination IS dollar data over the period 7 he furctasag pret Fr de etod 1973-7. While be praia pe [Nandi : Exchange Rate Dynamics : Further Empirical Evidence 359 meam= PtH ATH a where m is the logarithm of the ratios of the domestic to foreign money supply, pis the logarithm ofthe rato of the domestic to foreign price level, y is the logarithm of the ratio of domestic to foreign real income and ris the ifference between domestic and foreign interes rate Second, the price level adjustement equa Paes “P=, (0B D, @ where log and it i as fo tog D,=b, °F, ‘Thus the rate of inflation, p,, - Py which is the logarithm of the rat of prices of two periods, is proportional to the logarithm ofthe ratio of relative demand (o relative supply in the commodity market and this fe prices, which is shown in equation “The uncovered interest-arbitrage condition can be written as 1-420 @ ‘where x, is the expected change in the exchange rate e. gat ae, ta (mm) + a (m,- 4a, One +y Fain y ty correlated random variable and as satisty where u, isa first order s the following constraints 4 East, 4<0fori= isl 5, and 6 and a,>1 Further, the variables with asteriks (*) denote the logarithm ofthe variable of the foreign county, The constraint zg m1 says that purchasing power parity holds in the long run. The constraint a, > t says that there must be short run overshooting,360 Finance India 2. Data and Methodology The test ofthe model (eq ‘countries’ currencies, the refee = Eaype (1961 is conducted on the basis of data of six being in the parenthesis cares i U.S. daa relevant year, " fone Least Square method of estimation has been used, To te No: 24 = 1 dec sais is calculated by using the a indard! Table -1 ___Btimate of the Model: Six Countries/Currencies 07s (629 999 ae aap 6530 Gaon ) D ) cas Nandi : Exchange Rate Dynamics : Further Empirical Fvidence 361 Oo 0m as ost os 0s os os, om 46n as) ayy . » co ” 2» n 09 ans 09 a9 a2 ae 1m 238 st Ho Reject Ho Reet Ho Fall oreo Ho eset Mo Vabeorf sts 1 a9 on 1.99 Note : Figures in the parenthesis are t-statistic ‘esting of null hypothesis are at $ per cent level in all cases 3. Empirical Test of the Model and significant but positive and not significant for Egy the overshooting hypothesis is not supported. Again, of a, and a, are sign of, a,, and a, are postive, which is contrary to theory. of adjusted R? is good and because of the existence of lagged icon the right hand side we are not judging the value of Durbin Regarding the long ran Purchasing Power Panty restction we find that we {ait rect the mull hypothesis in ease of Morocco, Gerany and Greece, but incase of United Kingdom, Egypt and Japan, Thus In the case of Germany the sign ofa, a,, a, anda, are positive and only a, is negative and significant. The estimated value of significant. F United Kingdom, a, and a are negative and ta, anda, are © and significant, while a, is positive but not significant at 5 por cent The value of adjusted R? is good case of Egyptian pound the value of a, is positive but less than the le the value ofa, and a, are positive and significant. Here a, is postive significant, while a, anda, are negative, the latter being significant.