An Analysis of Factors Determining the USD-GBP Exchange Rate

Ian McGinnis

ECN 405: Applied Econometrics

Spring 2016

ABSTRACT. This paper employs time-series regression and OLS estimates in order to analyze the

factors which determine the USD-GBP exchange rate from 1970 through present. Through

literature review and economic consideration, exchange rate was regressed on GDP ratio, money

supply ratio, unemployment rate ratio, and the previous years exchange rate. The results suggest

that all but unemployment rate ratio are significant variables in determining the current exchange

rate. The model was determined to be a significantly good fit, overall, and few issues were found

through testing. Overall, results suggest that past years exchange rates are modeled very good

with this model and future work building on this model could be significant.
I. Introduction

The relationship between the United States and Great Britain is an important one on many fronts.

The relationship, deemed The Special Relationship has been one of the most important foreign

relationships for both the U.S. and G.B. for the past century (Harris, 2006). While this affiliation

could be outlined in pages upon pages of literature, there is a single component of it that affects

millions of people each day from the big banks to individual consumers, the exchange rate.

Exchange rates are determined in the foreign exchange market (FOREX), a market

composed of every currency from every country with trading 24 hours a day from Monday-

Friday, similar to stocks. This market is by far the largest in the world with trading totaling

roughly $1.9 trillion a day (Levinson, 2006). Books could be written about this fascinating

market, but the interest of this paper lies in one simple point, what determines these exchange

rates?

The objective of this paper is to use macroeconomic variables and a time-series model in

order to test the existing literature of exchange rate theory. By creating a reliable model that

follows both sound economic theory and passes tests to be a statistically consistent model, an

analysis of the factors that determine the USD-GBP exchange rate will be provided. I believe this

is an important (and interesting) project because works with similar scopes may be instrumental

in order to provide policy recommendations. Also, if development of these models could become

more reliable, personal fortunes are able to be made in the FOREX market (but you have to get

there first!)

II. Literature Review

Empirical studies that have tested various exchange rates and their determining variables

have concluded with mixed results. This section will outline the economic literature that was

crucial to this paper. The following papers provided important economic theory background and

statistical methods that are usefully employed to solve these problems.

 An econometric analysis of GDP growth and exchange rate in Ghana was done by Attah-

Obeng, Enu, Osei-Gyimah, and Opoku, using data from 1980-2012. The authors employed

multiple statistical methods such as ordinary least squares regression, graphing of a scatter plot,

and PPMC. The simple linear relationship between the Ghanaian Cedi and their GDP growth rate

was determined to be positive and strong. Also, the authors did tests for autocorrelation,

heteroskedasticity, and multicollinearity, where the former two were found to be absent. This

paper will provide guidance in terms of economic theory, due to the finding of the positive

relationship between GDP and exchange rate (Attah-Obeng, Enu, Osei-Gyimah, and Opoku

2013). Also, the various tests they performed will be similar to tests that will be run in this paper

with problems in time-series models.

Gregory P. Hoppers paper titled What determines the Exchange Rate: Economics

Factors or Market Sentiment? was useful in explaining the current monetary model which is

used to explain exchange rates. The model can be broken down to the simple explanation that

exchange rates are determined by the relative price levels of the two countries. What determines

these price levels is where the problem gets interesting. The monetary model uses the supply and

demand of money to explain the price levels, which implies that a faster growing money supply

in one country will depreciate that countries currency. This monetary model has been supported

in a paper by Frenkel (1978). This paper provides me with the economic backing that relative

money supplies are an important factor in the monetary model approach to determining exchange

rates, even if Hooper has some disagreements with the usefulness of this model (Hopper 1997).

Finally, crucial findings for the determination of the model that will be used in this paper

were explained by Bansal, Chereddy, Mehta, and Susanto in 2013. In an analysis of the Indian

Rupee exchange rate, using regression analysis, the authors tested many variables in order to find

the most significant variables in determining the exchange rate. The variables that were found to

be the best (in terms of significance) were unemployment rate ratio, inflation rate ratio, interest

rate ratio, government debt/GDP ratio, budget balance ratio, and government bond yield ratio.
(Bansal, Chereddy, Mehta, and Susanto, 2013). Therefore, this article was of great use in order to

determine what significant variables should be used in an analysis.

III. Description of the Model

A time-series model will be estimated for this analysis. A lagged variable is used when the impact

of the independent variable can be seen over multiple time periods (Studenmund, 2011, p. 405).

It should be noted that from here on out in this paper, any mention of GDP should be

assumed to be a calculation of GDP per capita. All GDPs are real (converted to a base year) and

to find GDP per capita the real GDP is divided by the population for that given year.

With the independent variables of GDP Ratio, Money Supply Ratio, and Unemployment

Rate Ratio, macroeconomics shows that there should be a lag between these indicators and their

effect on the economy. Therefore, each variable will be lagged by a single time period (1 year), in

order to account for this. Also, it is obvious to assume that the exchange rates from years past

would have an effect on the current interest rate, therefore a dynamic model will be used. The

following model, Equation III.1 will be the basis for the analysis:

Y t = 0 + 0 X t 1+ Y t1+ t (III.1)

The variables discussed above will be represented by Xs and the dependent variable,

exchange rate will be Y. The following (Equation III.2) is the model that will be estimated in the

final analysis and the null and alternative hypotheses (and a brief reasoning) for each independent

variable included in the model. The model is as follows:

EX RATEt = 0 + 0 GDPRATIOt 1+ 1 MS RATIOt 1+ 2 UR RATIOt1 + 0 EX RATEt 1+ t (III.2)

where 0 is the constant term and t is a classical error term.

Null and alternative hypotheses are as follows:

GDPRATIO t1

H 0: 0 0

HA: 0 < 0

This variable, the ratio of US/GB GDP, I would expect to have a negative coefficient. As

one country grows faster than the other, the currency for that country should appreciate, therefore,

as US_GSD/GB_GDP gets larger, the exchange rate of USD/GBP would go down, showing

appreciation in the dollar.

MS RATIOt 1

H 0: 1 0

HA: 1 > 0

This variable is the ratio of the money supplies of the dollar and the pound. As one money supply

increases relative to the other, that currency should be depreciating because of the increased

inflation associated with money supply growth. Therefore, it is expected that 1 would be

positive.

UR RATIOt 1

H 0: 2 0

HA: 2 <0

This variable is the ratio of the rate of unemployment of the U.S. to that of the U.K. As this ratio

grows unemployment is higher, relatively, in the U.S., so a depreciation of the dollar is to be

expected. Therefore, the expected sign of 2 is negative.

EX RATEt1

H 0: 0 0

HA: 0 < 0
Last years exchange rate should be positively correlated with the current rate, so it is expected

that 0 will be positive.

IV. Data Description and Model Estimation

Exchange rate (EX_RATE) and Gross Domestic Product (GDP_RATIO) data was found on a site

called Measuring Worth. This website has monetary data for centuries back and for many

countries, it was instrumental for this paper. United States money supply data was found on the

St. Louis Fed website and UK money supply data was located on the Bank of England website

(MS_RATIO_LAG). U.S. unemployment rate data is on the website for the Bureau of Labor

Statistics and this data for the U.K. is on the Office of National Statistics site (UR_RATE_LAG).

Data for the four independent variables (with lags) and the dependent variable used in the final

regression is described in Table 1:

Table 1-Descriptive Statistics

Variable N Minimum Maximum Mean Std. Deviation

EX_RATE 45 1.30 2.50 1.7607 .29933
GDP_RATIO_LAG 44 1.84 2.05 1.9383 .05183
MS_RATIO_LAG 45 3.93 23.13 9.3027 5.36532
UR_RATE_LAG 45 .59 1.88 .9621 .28952
EX_RATE_LAG 45 1.30 2.50 1.7607 .29933
Each variable is expressed as a ratio to keep consistent with the exchange rate which is

USD/GBP. GDP Ratio has one less observation because the 2016 GDP has not yet been

calculated.

Using the data from Table 1 and equation III.3 this model was estimated and Table 2

provides the results of this estimation:

 Table 2-OLS Regression Results

VARIABLE B STD. ERROR T-VALUE SIGNIFICANCE

CONSTANT 3.394 1.588 2.138 .039**
GDP_RATIO_LA -1.480 .779 -1.900 .065*

G
MS_RATIO_LAG .023 .010 2.312 .026**
UR_RATE_LAG -.131 .117 -1.124 .268
EX_RATE_LAG .638 .118 5.425 .000**
R = .884 R2 = .781 F = 34.804
* - indicates significance at the 10% level

** - indicates significance at the 5% level

The R2 is .781 meaning 78.1% of the total variation in this model is explained by the

independent variables. This is a strong correlation and shows that the given variables do a good

job of explaining the dependent variable. Also, as noted by the asterisks in Table 2 in the

significance column, MS_RATIO_LAG is significant at the 5% level, showing a low possibility

that this variable fit well due to chance and that it most likely represents the population rather

than just the sample. This is also true of EX_RATE_LAG, which is expected because of the strong

association between a variable and its lag. Also, GDP_RATIO_LAG has a significance level of .

065 which means that there is only a 6.5% chance that the observation reflects only the sample

and not the population. These numbers suggest that the null hypotheses for MS_RATIO_LAG,

EX_RATE_LAG, and GDP_RATIO_LAG can be rejected at the 10% level. The only null

hypothesis that cannot be rejected at the 10% level is UR_RATE_LAG.

The F-test is a test for overall goodness of fit. Using Table B-3 on p. 589 of Studenmund,

a critical F-statistic for 4 independent variables and 43 observations is 3.83 < 34.804. Therefore,

the final model estimation has a significant overall fit.

To test for multicollinearity, VIFs were calculated in SPSS. These are variance inflation

factors which test the amount a certain variable can be explained by all other independent
variables in the given equation (Studenmund, 2011, p. 259). Table 3 gives the VIF values for each

dependent variable in the equation.

Table 3-VIFs

Variable VIF
GDP_RATIO_LAG 3.599
MS_RATIO_AG 6.518
UR_RATE_LAG 2.592
EX_RATE_LAG 2.765
A VIF > 5 is considered to show severe multicollinearity. This would suggest that the

variable MS_RATIO_LAG has multicollinearity. However, due to the strong significance of the

variable, the strong economic theory that supports it, and the little redundancy that is noticed, it

has been decided that the variable will stay in the equation. Every other variable has a good VIF,

showing minimal multicollinearity.

Heteroskedasticity is a violation of one of the classical assumptions and it is the non-

constant variance of the error term. In order to test for heteroskedasticity, the Park test will be

conducted with a proportionality factor of time. This proportionality factor is a good choice

because what needs to be analyzed is if as the time-series model goes on, the variance in the

residuals has a changing variance or not. Therefore, the natural log of the squared residuals will

be regressed with the year variable. The regression results are noted in Table 4:

Table 4-Park Test Results

VARIABLE B STD. ERROR T-VALUE SIGNIFICANC

E
LN(YEAR) -112.867 52.747 -2.140 .038
R2=.098
At a 5% level, the coefficient of this variable is significant. Therefore, we can reject the

null hypothesis of homoskedasticity. This does not prove that there is heteroskedasticity in our

model, however it does make a pretty strong case for it. This could possibly mean our estimates
are not BLUE, but it cannot be sure. A graph shows somewhat constant variance when residuals

are plotted against the dependent variable EX_RATE, as shown in Graph 1:

Graph 1-Residuals vs. EX_RATE

Graph 1 provides a case for homoskedasticity due to the constant variance appearance of

the residuals, but no strong conclusion can be drawn from Graph 1.

Serial correlation occurs when the error terms from different time periods are correlated.

In order to test for serial correlation in a time-series model, a Lagrange Multiplier test will be

used, which uses residuals as the dependent variable and independent variables from the original

equation and a lagged term of the residuals as the independent variables. Then, using OLS and t-

tests, testing the null hypothesis that the coefficient of the lagged residuals term will reveal serial

correlation. With LM=NR2, LM=42(.256) =10.752. From Table B-8 of Studenmund, the critical
value of this test is 11.07 (5 def., 5%), so we can fail to reject the null hypothesis that the

coefficient of the lagged residuals is 0, so we can say there is a good chance there is no serial

correlation in the model.

When time-series variables are nonstationary, one of the properties of stationarity is not

met. With this test, it was concluded that we fail to reject the null hypothesis of nonstationarity

(with t=1-.294 and significance =.203). Therefore, a cointegration test was conducted, which is a

Dickey-Fuller test on the residuals of the original model. With t=-4.395 and significance = .000,

we can reject the null hypothesis of unit root in the residuals, and conclude that there is

cointegration in our model and the OLS estimates are not spurious.

V. Conclusions

This analysis deemed given variables as significant under initial estimation. Also, tests such as

VIFs and F-tests show low levels of multicollinearity and high goodness of fit. However, there

were a few problems that could be fixed with more time, expertise, and resources in the future.

One major problem found in the final model estimation was nonstationarity. This could

be expected due to the nature of macroeconomic variables. By inspecting the data, it can be

inferred that MS_RATIO_LAG is a strong candidate for nonstationarity. However, through a

Dickey-Fuller test on the residuals, cointegration was decided to be present in the model. Another

small problem was the possibility of heteroskedasticity in this model. This could be a

specification issue that is unnoticed or could be fixed with HC standard errors, hopefully making

sure that the model is BLUE.

Future work could build on this model. Suggestions such as fixing the nonstationarity,

more observations, and more independent variables may be able to provide an estimation that is

statistically significant and passes a multitude of criteria. Also, a further analysis could be

conducted where determinations are differing depending on economic depressions and

expansions. This could help determine the exchange rate depending on the state of the economy.
 Gregory P. Hopper hypothesized that the exchange rate may be determined by market

sentiment, and it could be a self-fulfilling prophecy. If this is the case, then market expectations

and consumer expectations will be the determining factors of the exchange rate, which is much

more difficult to model (Hopper 1997).

The policy implications of exchange rate determination could be huge for smoothing

monetary and fiscal policies. This could eliminate (or decrease) economic recessions in the future

and provide substantial and constant economic growth.

 Works Cited

"Bank of England Statistical Interactive Database." Bank of England Statistical Interactive

Database. Bank of England, 29 Apr. 2016. Web. 03 May 2016.

Bansal, Rishav, Chereddy, Manusha, Mehta, Kairavi, and Susanto, Hendry. What factors

significantly affect the INR to USD currency exchange rate?

Clegg, Richard. "Time Series: Unemployment Rate." Unemployment Rate - Office for National

Statistics. Office for National Statistics, 20 Apr. 2016. Web. 03 May 2016.

"Databases, Tables & Calculators by Subject." Bureau of Labor Statistics Data. Bureau of Labor

Statistics. Web. 03 May 2016. http://data.bls.gov/timeseries/LNS14000000

Enu, Prudence Attah-Obeng Patrick, and F. Osei-Gyimah CDK Opoku. "An Econometric

Analysis of the Relationship between Gdp Growth Rate and Exchange Rate in Ghana."

Harris, Robin. Beyond Friendship: The Future of Anglo-American Relations. Washington, DC:

Heritage Foundation, 2006. Print.

Hopper, Gregory P. What Determines the Exchange Rate: Economic Factors or Market

Sentiment? Business Review. (1997).

Johnston, Louis and Williamson, Samuel H., "What Was the U.S. GDP Then?" MeasuringWorth,

URL: http://www.measuringworth.org/usgdp/

Levinson, Marc. Guide to Financial Markets. Princeton, NJ: Bloomberg, 2006. Print.

"M2 Money Stock." St. Louis - FRED. 21 Apr. 2016. Web. 03 May 2016.

Officer, Lawrence H., "Dollar-Pound Exchange Rate From 1791," MeasuringWorth, 2016

URL: http://www.measuringworth.com/exchangepound/

Studenmund, A. H. Using Econometrics: A Practical Guide. Boston, MA: Addison Wesley, 2011.

Print. Chapter 12 - Time-Series Models.

Williamson, Samuel H., "What Was the U.K. GDP Then?" MeasuringWorth, 2016

URL: http://www.measuringworth.com/ukgdp/