International Research Journal of Finance and Economics ISSN 1450-2887 Issue 46 (2010) EuroJournals Publishing, Inc. 2010 http://www.eurojournals.com/finance.

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Causal Relationship between Macroeconomic Variable and Exchange Rate

Ramiz ur Rehman Assistant Professor, Lahore Business School, University of Lahore, Pakistan E-mail: ramiz_rehman@hotmail.com Tel: +92-4235321456-60; Fax: +92-4235321760 Muhammad Ateeq ur Rehman Lecturer, Lahore Business School, University of Lahore, Pakistan Awais Raoof Associate Professor, Lahore Business School, University of Lahore, Pakistan E-mail; awais_raoof@hotmail.com Tel: +92-4235321456-60; Fax: +92-4235321760 Abstract This paper investigates the relationship between inflation, interest rates and exchange rates. The study contains the previous work to support the robust study to find the impact of independent variables on dependent variable. In this case, interest rates and inflation is taken as independent variable and exchange rate as dependent variable. To find out the impact of these variables, data of interest rates (Pakistan and United Kingdom), inflation (Pakistan and United Kingdom) and exchange rate between Pakistan Rupee and British Pond Sterling of the last fifteen years (1994-2009) on monthly basis are analyzed. A Multiple Regression Model is applied to check the relationship of inflation and interest with exchange rate. Results show that a significant but positive relation is found between inflation and exchange rate while a negative and significant relation is fond between interest rate and exchange rate. This study can be further extended to check the lead-lagged effect of these independent variables on dependent variable.

Keywords: Exchange rate, Interest rate differential, inflation differential

1. Introduction
Interest rates, inflation and exchange rates are three important drivers of any economy. Inflation means continuously increase in price of goods and services which lead to depreciate the respective currency. So many theories have already been addressed on the core concept of inflation, its causes and its impact on overall economy. A major root cause of inflation is excessive supply of money in an economy. This causes price hike in an economy which reduces the purchasing power of a currency. Before globalization, the impact of inflation is confined to the national boundaries, but now it crosses the boarder and percolates on both developing and developed nations. Interest rates are the rates at which one can borrow or lend the money in an economy. Interest rates are also used to control the inflation of the economy. There are different schools of thoughts available that emphasize on different factors and plan to control inflation like, controlling money supply, providing goods and services as

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per the increase demand, introducing price controlling authorities, managing interest rates and fixing exchange rates. But interest rates are very frequently used to control inflation. High interest rates discourage the money supply and encourage savings. So fundamentally, there is a very close relationship between the interest rates and inflation. In the era of globalization, both these factors have significant impact on the exchange rate as well. Theoretically, the relationship between interest rates, inflation and exchange rate was established by the International Fisher Effect (IFE) and Purchasing Power Parity (PPP). But these theories have yet to be tested on different economies to ascertain the empirical evidence of such relationship. These experiments will provide guiding principles to the investors and policy maker, who deal with these variables on daily basis. Moreover, Governments can make their policies in the interest of investors as well as the corporate persons and to stream line the vivid economy. The major objective of this paper is to investigate the impact of inflation and interest on the exchange rate. It also provides deep view of the factors in determination of the exchange rate with empirical evidence. In order to find the relation between dependent and independent variables, multiple regression technique is applied. The robust work enhances the body of knowledge at academic level in Pakistan with various logical means. Firstly, it includes the evidences of inflation, interest and exchange rate from 1994 to 2009 which cover 15 year observation related to such variables. Secondly, before this study less work is done with respect to the Pakistani market phenomenon. Last but not least, it is opening statement in determining the exchange rate system which will help to the policy maker as well as it enhance the knowledge at scholastic level. A significant but positive relation is found between inflation and exchange rate while there is negative and significant relation between interest rate and exchange rate The remaining paper is arranged as follow; section two discusses the previous work related to robust study. Section three reveals the methodology of existing work while section four includes the results and discussion. The last section contains conclusion of the current work.

2. Literature Review
Information plays an important role to change the business scenario and it also change the expectation of the people regarding market. Therefore foreign investors require more return if risk is more to relative country. Such information is perceived from different macroeconomic variables. For example, information related uncovered interest rate can change the exchange rate and risk premium between two countries (Duartea and Stockman, 2005). Macroeconomic variables can change the economic phenomenon as well as it leads to change the exchange rate at domestic level. Nominal or real change in the interest rate is the main important feature of the monetary policy and it reason to change the exchange rate. In addition, the positive change in real or nominal interest at domestic level can appreciate the exchange rate at domestic level and vice verse (Kim and Roubini, 2000). However, information regarding macroeconomic variables can be divided into two types whether it is strong or weak. But strong announcement of macro economic variables reason to appreciate the exchange rate. Although in long run there is a co movement in interest and exchange rate and this movement also leads to require the risk premium (Fausta et. al., 2007). Moreover, daily intervention by central economic authority also set the exchange rate but the benefit can be achieved for short term not for long term (Dominguez, 2006). Subsequently, economic news related macroeconomic variables like interest; inflation and monetary policy increase or decrease the value of the currency. In addition, positive change in fundamental of the economy can appreciate the value of currency while unexpected negative change in the economic variable leads to decrease the value the domestic currency (Ehrmann and Fratzscher, 2005). Consequently, variation in inflation also changes the spot and forward exchange rate while it depends upon direction of the inflation of one country to other country. In addition, it is observed positive change in exchange rate if direction of inflation in two countries is same but domestic inflation remains low as compare to other country (Simpson et. al., 2005). However,

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macroeconomic variable and exchange rate are positively correlated but it depends upon the time duration (Ray, 2008). Accordingly, inflation and interest rate both have negative relation with nominal exchange rate. However, expectation regarding real exchange rate has positive relation with nominal exchange rate (Hsing, 2007). On the other hand, there is a co movement between interest rate and exchange rate and sensitivity depends upon the monetary structure of the relative country. The country having strong monetary structure has low co movement between exchange rate and interest rate (Holtemoller, 2005). The above literature denotes the importance of interest rate and inflation in the determining the exchange rate. The existing work also investigates the relation of inflation and interest with exchange rate. However, less work is done on this issue related to Pakistani scenario and the robust work enhances the knowledge at academic level as well as domestic level.

3. Methodology
In order to find the relation of interest and inflation with exchange rate, a monthly data of same variables are used from 1994-2009. In addition, on the basis of previous literature following hypothesis has been developed. Hypothesis 1 H0: There is no relation between interest rate and exchange rate Hypothesis 2 H0: There is no relation between inflation and exchange rate. The following equation shows the mathematical relation of dependent and independent variable. Ex.Rate = + 1 (Int.Diff )t + 2 (Inf .Diff )t + t (1) Where Ex.Rate = Exchange Rate Int.Diff = Interest Rate Differential Inf .Diff = Inflation Differential t = Error term In contemporary study interest rate differential of Pakistan and UK is taken as independent variable while inflation differential is used as second independent variable. Moreover, exchange rate of Pak rupee to UK Pound is taken as a dependent variable while the information related interest rate and inflation is taken from SBP1 which is a reliable source at domestic level. Moreover, exchange rate is taken from (www.x-rate.com). The correlation matrix is used to check the negative or positive relation of independent variable with dependent variable. In addition, OLS model is applied to check the significance of the variable at individual and collective level.

4. Results and Discussion

The analysis regarding descriptive statistics of exchange rate, interest rate differential and inflation differential is shown in Table 1. The mean value of exchange rate, interest rate differential and inflation differential is 89.24, 7.24% and 6.55% respectively. Moreover, the median of exchange rate and inflation is 88.99 and 6.55% correspondingly while the value of interest rate is 7%. Consequently,
1

State Bank of Pakistan

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the variation of exchange rate from mean value is 25.40 and inflation deviate 4.40% from its mean value while a 3.28% of deviation is found in interest rate differential. The correlation result of exchange rate, interest rate differential and inflation Differential is given in Table 2.
Table 1: Descriptive Statistics
Ex. Rate 89.24 88.99 25.40 44.87 141.04 Inf. Diff 6.55 5.8 4.40 0 20.9 Int. Diff 7.24 7 3.28 2.75 14.5

Mean Median Std. Dev Minimum Maximum

The results shown in correlation matrix reveal the positive relation between inflation differential and exchange rate while there is strong negative correlation between interest rate differential and exchange rate. In addition, a strong positive correlation is found between interest rate differential and inflation differential.0
Table 2: Correlation Matrix
Ex. Rate 1 0.11 -0.45 Inf. Diff 1 0.49 Int. Diff

Ex. Rate Inf. Diff Int. Diff

In Table 3, multiple regression results are shown and reveal the significant relation of exchange rate with interest rate differential and inflation differential. Overall model is explained by 35% based on a total of 188 observations. Inflation differential has positive coefficient (2.52) while t-value (6.47) shows that individually inflation differential reason to change the exchange rate along with significant p-value (0.000) which is less than 0.05. On the other hand, interest rate differential has negative coefficient with exchange rate. As far as the t-value is concerned it is -9.94 and it shows independently there is significant but negative effect of interest rate differential on exchange rate. Consequently, pvalue (0.000) also shows the significance of interest rate differential which is less than 0.05. On behalf of above mentioned result, it can be said that inflation and interest rate differential are the most important tool to determine the exchange rate in the Pakistani market scenario if it is compared with UK currency Pound. Individually, Inflation has positive impact on the exchange rate and by this mean if inflation has increasing trend then it lead to increase domestic exchange rate as Simpson et. al., (2005) also have the same result in their study.
Table 3: Multiple Regression Analysis
SS 42903.9922 77773.4284 120677.421 Coef. 2.526975 -5.206892 110.3921 df 2 185 187 MS 21451.9961 420.39691 645.3338 t 6.47 -9.94 29.87 P>|t| 0.000 0.000 0.000 Number of obs F( 2, 185) Prob > F R-squared Adj R-squared Root MSE = = = = = = 188 51.03 0.0000 0.3555 0.3486 20.504

Source Model Residual Total erd infdiff intdiff _cons

Std. Err. .3906198 .5240706 3.696193

[95% Conf. Interval] 1.756333 -6.240815 103.1 3.297617 -4.172969 117.6842

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On the other hand, an inverse relation is found between interest rate differential and exchange rate of both countries UK and Pakistan. Duartea and Stockman (2005) also reveal that if interest rate increases then the foreign investors require more return which means domestic currency depreciate. In so far as there is negative impact of interest on the exchange rate. Hence this problem can be due to instable situation of Pakistani economy.

5. Conclusion
The main objective of this robust work is to find the impact of inflation and interest on the exchange rate. On behalf of a total of 15 years data from 1994 to 2009, following results are found which reject the null hypothesis and accept the alternative hypothesis. There is a significant but positive relation between inflation and exchange rate of UK and Pakistan. There is significant but negative relation of interest and exchange rate of Pakistan and UK. Further research can discover the lead-lag relation between inflation and exchange rate. Moreover, lead-lag relation between interest and exchange rate can also be looked into future research.

Reference
[1] [2] Duartea, M. and Stockman, A. C. (2005), Rational speculation and exchange rates, Journal of Monetary Economics, Vol. 52, pp. 329 Dominguez, K.M.E. (2006), When do central bank interventions influence intra-daily and longer-term exchange rate movements?, Journal of International Money and Finance, Vol. 25, pp.1051-1071 Ehrmann, M. and Fratzscher, M. (2005), Exchange rates and fundamentals: new evidence from real-time data, Journal of International Money and Finance, Vol. 24, pp. 317-341. Fausta, J., Rogersa, J. H., Wangb, S. B. and Wrightc, J. H. (2007), The high-frequency response of exchange rates and interest rates to macroeconomic announcements, Journal of Monetary Economics, Vol. 54, pp.10511068. Hsing, Y. (2007), Exchange rate fluctuations in Croatia: test of uncovered interest rate parity and the open economy model, Applied Economics Letters, Vol. 14, pp. 785788 Holtemoller, O. (2005), Uncovered interest rate parity and analysis of monetary convergence of potential EMU accession countries, IEEP, Vol. 2, pp. 3363 Kim, S. and Roubini, N. (2000), Exchange rate anomalies in the industrial countries: A solution with a structural VAR approach, Journal of Monetary Economics, Vol. 45, pp. 561-586 Ray, H. (2008), Dynamic Interactions of Exchange Rates, Stock Prices and Macroeconomic Variables in India, The Icfai University Press, India Simpson, M. W., Ramchander, S. and Chaudhry, M. (2005), The impact of macroeconomic surprises on spot and forward foreign exchange markets, Journal of International Money and Finance, Vol. 24, pp. 693-718

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