The Determination of the Real

Exchange Rate in the Long-Run:

Evidence from United Kingdom

George Iordache
Financial Economics Dissertation
(2014)

Abstract

This paper focuses on the determination of the real exchange rate in the long-run having as a
domestic country the United Kingdom and as a partner country the United States. The main
determinants which are examined are: Total investment as a percentage of GDP, Inflation,
Unemployment, Terms of trade differentials, GDP per capita differential and 10-year
government bonds interest rate differentials. Using spss I ran an OLS regression on annual
data (1980-2013) to analyze the relationship between the above variables and the real
exchange rate in the long-run.

The main limitation of this paper is the methodology used, simple OLS regression which
might also be the reason behind the interesting results observed. According to previous papers
Terms of trade differentials should be a determinant of the real exchange rate but because the
nature of the relationship is not linear, the OLS regression fails to view this variable as a
determinant.

Keywords: real exchange rate determination, economic fundamentals, PPP, FEER, BEER,
United Kingdom

UB:11005648 Page 1
 Statement of Authenticity

I certify that this dissertation is all my

own work.

George Iordache
5 May, 2014

UB:11005648 Page 2
Contents
1. Area and context of research.....................................4
2. Theoretical Framework..............................................5
2.1 Purchasing Power Parity.........................................5
2.2 Fundamental Equilibrium Exchange Rates.............8
2.3 Behavioural Equilibrium Exchange Rate..............10
3. Empirical / Contextual Literature review.................12
4. Methodology............................................................15
5. Data Analysis............................................................18
5.1 Descriptive statistics.............................................18
5.2 Multicollinearity and autocorrelation tests.........21
5.3 Regression analysis...............................................22
6. Limitations & Further Research................................25
7.Conclusion.................................................................27
Reference list................................................................28
Bibliography..................................................................29

UB:11005648 Page 3
1. Area and context of research

Globalization left its mark on the economic interactions of today, exchange rates play an
increasingly more important role in the trades between countries, and thus knowing how to
predict them is a valuable skill. The exchange rate is the price of the currency; therefore we
must look at the factors that influence the demand and supply forces. What makes this
research attractive and challenging is the volatility of the exchange rate. Exchange rates are
important for both the private sector as well as the public one. People, firms, central banks,
commercial banks, corporations and governments buy foreign currencies, thus they are
affected by them. Knowing how to predict the movements of the exchange rate can increase
your wealth, hence corporations, banks and different financial institutions try to extract profits
from the exchange rates movements. Another factor which makes this topic attractive and
complex at the same time is the fact that the factors that influence the exchange rate are
diverse. Not only economic phenomenon but also social, political and even natural can have
an impact on exchange rates. The spectrum of factors that influence the exchange rate makes
its determination process attracting and challenging.

For centuries the exchange rates have been backed by gold, the most recent attempt to
coordinate exchange rates using gold happened in 1944 at Bretton Woods, New Hampshire.
(P. R. Krugman et. all, 2012) According to Keith Pilbeam (1992) this system failed to bring
the full employment and price stability promised and in 1973 the president of the United
States, Richard Nixon, ended it. After this period as Mark Baimbridge et. all (2000) suggests
floating exchange rates appeared. These flexible exchange rates are of two types “clean float”
where the government does not intervene and “dirty float”, the case where the government
buy and sell currencies to control the exchange rate. With the introduction of the flexible
exchange rates a new body of literature was created, dedicated to answer what exactly
determines exchange rates. (Devereux, 1997)

Having highlighted the core of this paper I can move forward and give a description of the
structure of this paper.

The second chapter is the theoretical framework which is divided in 3 sections. The first
section refers to PPP or Purchasing power parity model and its drawbacks. The second section
focuses on Fundamental equilibrium exchange rate or FEER and the last section covers
Behavioural Equilibrium Exchange Rate or BEER. The third chapter is the empirical/
contextual literature review on BEER method which is going to be used furthermore to
examine how specific determinants influence the exchange rate. The forth chapter gives an
overview on the model and data that I am going to use. The fifth chapter analyzes the data and
presents the multicollinearity and autocorrelation tests. The final part consists of
limitation/further research chapter and conclusions which summarizes the main findings of
this paper.

UB:11005648 Page 4
2. Theoretical Framework

2.1 Purchasing Power Parity

The first section will focus on Purchasing Power Parity (PPP) theory because this is the
starting point for most of the exchange rate determination models. (Abuaf N. and P. Jorion,
1990) According to (Copeland, 1994) PPP theory appeared first in the sixteenth century in
Spain; David Ricardo revived it in the nineteenth century and a Swedish economist Gustav
Cassel talked about it between WW1 and WW2. The building block for PPP as Krugman
(2012) argues is the Law of one price which states that two identical goods from different
countries have the same price when expressed in the same currency, in the absence of
transportation costs and trade barriers.

PiUS = E$/€ x PiE(1.1) => E$/€ = PiUS / PiE (1.2)

Pi = price of good i in US or Europe

E$/€ = Nominal Exchange Rate

Having discussed LOOP we can now explain PPP theory. PPP implies that the exchange rate
between 2 countries equals the ratio of the countries price levels. (Krugman, 2012)

E$/€ = PUS / PE (1.3)

Notice: We no longer use the superscript “i” because now the price is not for an individual
good but for a basket of goods.

The above version of PPP is the absolute one which does not give a realistic description of the
world because the basket of goods that is used for the price index in one country might be
different from the basket of goods used in another country.(Copeland, 1994) To remediate
this drawback as Copeland (1994) argued we need to introduce the relative PPP "One
country's inflation rate can only be higher (lower) than another's to the extent that its
exchange rate depreciates (appreciates)". Because relative PPP focuses on percentage change
it deals with the issue of price indexes. (Copeland, 1994)

(E$/€,t - E$/€,t-1) / E$/€,t-1 = πus,t - πE,t where πt = (Pt - Pt-1) / Pt-1 (price levels /inflation) (1.4)

(Krugman, 2012)

Relative PPP switches from focusing on prices and exchange rate levels to prices and
exchange rate percentage changes. Until this point PPP theory might seem an efficient way of
explaining the exchange rate but as Copeland (1994) argues it fails to describe the short-run
volatility and also the long-run movements. Krugman (2012) sustain that there are 3 main
reasons why PPP fails to illustrate the reality:

1. Trade Barriers and Nontradable goods

UB:11005648 Page 5
Transportation costs, trade tariffs and nontradable goods can cause movements in the
exchange rate which are not accounted by PPP theory. Because PPP is maintained through
arbitrage the above trade impediments restrain the arbitrage process. This division of the
economy into 2 sectors, traded and nontradable goods according to Copeland (1994) may
further affect the PPP theory's validity. Discrepancies in prices for nontradable goods between
countries are not going to be eliminated because arbitrage cannot be used, thus exchange rate
will deviate further from PPP levels.

2. Departure from free competition

Firms with monopolistic or oligopolistic power might strengthen the current trade barriers;
hence exchange rate levels will not be consistent with PPP theory. Copeland (1994) suggests
that PPP theory does not take in consideration the risk factor.

3. Differences in consumption patterns and price level measurement

Although relative PPP eliminates some of the problems caused by the differences in the
composition of the baskets among countries, it fails to correct the problems that appear when
the price of a certain good from the basket changes. This is the case because a certain good
might count for a different share of the basket in country A than in country B, also it is very
difficult to approximate the exact share.

These drawbacks lead to the PPP Puzzle which refers to the fact although the exchange rate is
highly volatile in the short-run, the process of converging to the predictited rate by PPP model
is very slow (3 to 5 years convergence half life).

q$/€ = ( E$/€ x PE) / PUS (1.5)

According to Krugman (2012) equation 1.5 will help us quantify the deviations from PPP.

(real ER will equal 1 when relative PPP holds) (Krugman, 2012)

PUS = the dollar price of an unchanging basket containing the typical weekly purchases of US
households and firms.

PE = the euro price of an unchanging basket containing the typical weekly purchases of
Europe households and firms.

Krugman (2012) argues that a change in the real exchange rate is equal to the percentage
change in the nominal exchange rate less the differences in inflation between the domestic
and the foreign economy.

(qe$/€ - q$/€ )/ q$/€ = [( Ee$/€ -E$/€) / E$/€] - (πeUS - πeE) (1.6)

R$ - R€ = ( Ee$/€ - E$/€) / E$/€ (1.7) (Krugman, 2012)

Equation 1.6 plus the interest rate parity condition (equation 1.7) gives us the equation for the
real exchange rate.

R$ - R€ = (qe$/€ - q$/€ )/ q$/€ + (πeUS - πeE) (1.8)

But we still have to incorporate the real interest rate: re = R - πe (1.9).

UB:11005648 Page 6
reUS - reE = (R$ - πeUS) - (R€ - πeE) (1.10) => reUS = reE + (qe$/€ - q$/€ )/ q$/€ (1.11)

(reUS = reE when PPP holds)

UB:11005648 Page 7
2.2 Fundamental Equilibrium Exchange Rates

Furthermore, the second section will focus on the Fundamental Equilibrium Exchange Rates
theory or FEER. Fundamental refers to the fact that we focus on variables and conditions
related to long-run, thus FEER is a model used to calculate the value of the exchange rate
over the medium to long term (MacDonald R. et. all, 1998).According to MacDonald R. et.
all (1998) FEER is defined as the real exchange rate which is consistent with the
macroeconomic balance, therefore we must have an internal and external balance. The
internal balance is defined as the level of output at which we have full employment and low,
sustainable inflation. The external balance is achieved when the trading countries which have
internal balance maintain a desired flow of resources. The FEER method as MacDonald R. et.
all (1998) suggested will give the equilibrium exchange rate that would be reached in "Ideal
economic conditions".

The basic equation of this model is: CA = -KA (2.1) where CA is the current account and
KA is capital account. (MacDonald R. et. all, 1998)

FEER as MacDonald R. et. all, (1998) states looks at the determinants of the current account.
The current account is affected by the domestic (Yd) and foreign (Yf) aggregate output and by
the real exchange rate (q) (MacDonald R. et. all, 1998).

CA = b0 + b1 x q + b2 x Yd + b3 x Yf = -KA (2.2)

b1< 0, b2<0, b3>0 and q, Yd, Yf are set at Long-Run equilibrium levels.

From the above equation we can rearrange the factors and obtain the FEER.

FEER = (-KA - b0 - b2 x Yd - b3 x Yf) /b1 (2.3)

MacDonald R. et. all, (1998) argues that FEER is a method of calculation, thus it does not
contain a theory of real exchange rate determination. The main assumption is that the real
exchange rate converges over time to FEER but this model does not state which forces will
eliminate the difference between current ER and FEER (MacDonald R. et. all, 1998). In order
to evaluate the current exchange rate

q > FEER (over evaluated) or q < FEER (under evaluated)

we must first calculate a projected CA which is consistent with internal balances in the
economies participating in trade (MacDonald R. et. all, 1998). After reaching an approximate
of the CA we will compare it with the KA, FEER will be the exchange rate that will make CA
= -KA (MacDonald R. et. all, 1998).

To reach FEER we must follow 3 steps:

- construct a current account model

- estimate the potential output of the domestic and foreign economies

- estimate the KA

UB:11005648 Page 8
MacDonald R. et. all, (1998) states that capital account equilibrium value equals the
difference between savings and investment at full employment level.

( -KA) = S - I (2.4) => FEER = ( S - I - b0 - b2 x Yd - b3 xYf) / b1 (2.5)

MacDonald R. et. all, (1998) argues that this method has 3 drawbacks:

1. It is complicated to estimate the potential output for the domestic and foreign economies.

2. Does not incorporate a theory of exchange rate determination

3. Does not assess how stock equilibrium considerations affect the exchange rate.

UB:11005648 Page 9
2.3 Behavioural Equilibrium Exchange Rate

The third section focuses on the Behavioural Equilibrium Exchange Rate, this is the method
used in this paper to examine how specific determinants affect the exchange rate. BEER
measures the difference between the current real exchange rate and the estimated value
consistent with fundamentals equilibrium ( R. MacDonald, 1998).

According to MacDonald R. et. all, (1998) BEER method requires an analysis of the
fundamental variables in the economy. This theory of exchange rate determination
incorporates 2 co-integrated vectors one for long-run and one for short-run; our interest is in
the components of the long-run vector.

Long-run vector building blocks: - Terms of trade

- Relative price of nontraded to traded goods

- The stock of net foreign assets

- Proxy for risk premium

Short-run vector building block: -interest rate differentials

(MacDonald R. et. all, 1998)

The fundamental equation of this theory is the following:

qt = β1x Z1t + β2 x Z2t + ʈ' x Tt + Ƹt (3.1)

Z1 = a vector of economic fundamentals that influence the exchange rate in the long-run.

Z2 = a vector of economic fundamentals that affect the exchange rate over the medium term.

β1,β2 = vector of reduced form coefficients

T = a vector which contains factors that influence exchange rate in the short-run.

ʈ = vector of reduced form coefficients

Ƹt = the disturbance term

(MacDonald R. et. all, 1998)

As 3.1 equation suggests the real exchange rate is explained by a set of fundamentals Z1, Z2
plus a group of variables that influence it in the short-run T and the disturbance term Ƹt.

BEER does not only analyse what determines the exchange rate but also compare it with the
equilibrium value, in order to do this we need to introduce the current misalignment (cmt) and
the total misalignment (tmt).

UB:11005648 Page 10
MacDonald R. et. all (1998) states that the current misalignment is the difference between the
actual real exchange rate and the real exchange rate given by the current values of all the
economic fundamental.

Current exchange rate: q't = B'1 x Z1t + B'2 x Z2t (3.2)

cmt = qt - q't = qt - B'1 x Z1t + B'2 x Z2t = ʈ' x Tt + Ƹt (3.3) (from equation 3.1)

The total misalignment is defined because the current values of the fundamentals might not be
at the desired level. MacDonald R. et. all (1998) states that the total misalignment is given by
the difference between the current real exchange rate and the exchange rate obtained when the
fundamentals are at the desired levels.

tmt = qt - B'1 x Z1t + B'2 x Z2t(3.4)

(The bar at the bottom represents that the variables are at long-run equilibrium)

tmt = (qt - q't) + [B'1 (Z1t - Z1t) + B'2 (Z2t - Z2t)] (3.5)

The first brackets represent the cmt and the second set of brackets show the current deviation
of the fundamentals from their long-run values.

From equation 3.3 => tmt = ʈ' x Tt + Ƹt + [B'1 (Z1t - Z1t) + B'2 (Z2t - Z2t)] (3.6)

Thus the exchange rate is explained through: transitory factors, random disturbances and
deviations of fundamentals from long-run values.

MacDonald R. et. all (1998) argues that BEER model is more complete than FEER because
can explain cyclical movements in the exchange rate, also BEER's variables included in the
vectors for short and long-run can be manipulated and changed, therefore the researcher can
include the set of factors that he wants to test.

UB:11005648 Page 11
3. Empirical / Contextual Literature review

Ronald MacDonald (2004) provides evidence that BEER is better than competing approaches
in terms of tractability and transparency. His starting point is purchasing power parity and the
failure of this theory due to random walk.

Ronald MacDonald (2004) states that real exchange rate depends on the actual rate and the
interest rate differentials.

qt’= qt+ (rt – rt*)

qt = actual rate (influenced by the following fundamentals)

Variables:

 The ratio of net foreign assets to GDP (nfa) (is affected by demographics and
structural fiscal balances)
 Labour productivity relative to trading partners (lprodt)
 Output gap relative to output gap of trading partners (gapd)
 Terms of trade (ltot)
 The ratio of total trade to GDP (ltotta)
 Log of property price (lprop)
 Log of private and government consumption ( lpcon) (lfcon)

qt = f(nfa [+], lprod [+], gapd [+], ltot [+], ltotta [-], lprop [+], lpcon [+], lfcon [+])

To conclude, this study gives a set of variables that I will assess in my paper and also gives
predictions of their relationship with the exchange rate (the signs in the brackets).

MacDonald and Preethike Dias (2007) uses the behaviour equilibrium exchange rates (BEER)
of Clark and MacDonald (1999) on a mix of 10 developed and developing countries. This
paper gives an insight on how to build the BEER equation, MacDonald and Preethike Dias
(2007) use the following variables:

 net exports as a proportion of GDP

 real interest rate differential
 terms of trade differential
 GDP per capita differential

MacDonald et all. (2007) also suggests another reason on why we need the calculate the
exchange rate, they argues that central European countries that recently became members of
the EU need to know the appropriate exchange rate value for entry into the EU.

BEER approach is a general method of modelling equilibrium exchange rates, MacDonald et

all.(2007) argues that the core element of most BEER applications is the requirement that the

UB:11005648 Page 12
current account should be zero in equilibrium. BEER method has the potential to include all
the fundamental movements of exchange rates according to this paper.

The structure of the equation for the actual real ER is the basic one for BEER, 3 vectors one
containing short-run factors, one for medium term and the third one for long-run variables
plus the random error.

qt = β1x Z1t + β2 x Z2t + ʈ' x Tt + Ƹt

This paper also covers the current misalignment and the total misalignment.
This journal is particular useful for me because not only gives step by step instruction but also
show the statistic which can later be compared with my results.

Drine I. et. all (2003), presents how a set of variables affect the real exchange rate in the long
run. His set of factors are the following:

- domestic investment
- the share of public spending in the GDP
- trade policy
- GDP per capita
- foreign direct investment flows
- terms of trade

Drine I. et. all (2003) argues that only real variables can influence the exchange rate
equilibrium in the long-run. According to his paper by reducing the tariffs imposed on
imports the exchange rate is going to depreciate. Policies that aim that are going to increase
the income and part of that raise is going to be used to consume more imports, thus causing a
depreciation. Drine I. et. all (2003) explains that an increase in net capital flows or in net
foreign assets earnings will appreciate the exchange rate also according to Edwards (1989) the
same effect will have an investment in exports or non-tradable goods. Drine I. et. all (2003)
ending remark is that terms of trade, capital flows and GDP per capita are positively related to
long-run real exchange rate, while domestic investment and the degree of openness of the
economy are negatively related.

Jorge Carrera (2008) provides in his paper a set of factors that influence the real exchange rate
and gives predictions on the nature of influence, positive or negative. The real exchange rate
according to Jorge Carrera (2008) is the relative price of the non traded to traded goods that is
consistent with internal and external balance. His paper covers aspects like government
spending, degree of openness, terms of trade, capital flows and net foreign assets (Jorge
Carrera, 2008).

Furthermore, I will summarize his findings on the above variables. The exchange rate will
appreciate if government spending increases; according to his study the increase in spending
will cause an increase in prices, thus in the exchange rate as well (Jorge Carrera, 2008). The
degree of openness affects the fluctuations in the exchange rate. Jorge Carrera, 2008 argues
that the higher the degree of openness the smaller are the fluctuations, also he observed that
policies to raise the level of openness will depreciate the real exchange rate.

Jorge Carrera (2008) states that an improvement in terms of trade will appreciate the real
exchange rate. Also he highlights the positive relationship between capital flows and real

UB:11005648 Page 13
exchange rate, as foreign investment raises the real exchange rate appreciates (Jorge Carrera,
2008). This is the result of the increase in demand for our currency.

As I highlighted earlier BEER approach is preferred by many researchers because you can
adapt it and include only the factors that you wish to analyse. Furthermore, I will give a brief
description of Faruqee’s paper. This paper provides a better overview of the BEER method
and also shows a good path on how to reach a long-run real exchange rate equation. Faruqee
and Stein (1995) both start with the balance of payments equation:

CA = KA (4.1)

They argue that productivity and thrift affect the capital account and the exchange rate
through the current account, also this method incorporates the stock equilibrium conditions.
The current account is dependent on the exchange rate, exogenous variable and the interest
rate received/ paid on a country's net foreign asset/ debt position (F) (Faruqee, 1995).

CA = c x q + X + r x F c< 0 (4.2)

q = exchange rate

X = exogenous variables

r = domestic interest rate

The desired net capital flow is expressed by the following equation.

KAd = d( r - r*) + f (Fd - F) d<0, f>0 (4.3)

r* = world real interest rate

Fd =target level of net foreign assets

From equation 4.2 and 4.3 we can get the equilibrium balance of payment equation which
implies that desired excess of income over spending equals desired net variations in claims on
foreigners. (Faruqee, 1995)

c x q + X +r x F = d (r-r*) + f (Fd - F) (4.4.)

Faruqee (1995) argues that the real exchange rate is a function of the factors that influence the
current and capital account; he also does not focus on internal and external balance. From his
point of view the exogenous variables which influence the current account are productivity
growth differentials, terms of trade and the relative price of non-traded goods.

His method gives a trend not just an equilibrium value and emphasizes one issue with BEER
theory. According to Faruqee (1995) it is unknown if the difference between the estimated
BEER and the actual exchange rate is true misalignment or specification error (not
incorporating all the fundamentals that influence ER). (Faruqee, 1995)

UB:11005648 Page 14
4. Methodology

To study the determinants of the real exchange rate in the long-run for United Kingdom I will
use a time series data set. I will get annual data from 1980 until 2013 from OECD Statistics
and IMF Data and Statistics, thus giving me a sample size of 34. The method used to analyze
the determinants of the real exchange rate in the LR is a SPSS OLS regression. Although I am
aware that a Cointegrated VAR model is more suitable, but this is too advanced for this paper.
(Michael Hauser, 2014) The partner country for the UK economy will be the USA economy.

Furthermore, I will analyze the advantages and disadvantages of this type of test. According
to Samuel Cameron (2005) the OLS regression uses data very efficiently; with only a sample
size of 30 one can obtain statistical significant tests. Another advantage of this method is that
the results are easy to analyze and interpret. One of the drawbacks of this method is that it
only analyzes if there is a linear relationship between the dependent and independent
variables, also it has a high sensibility to outliers. Another issue is that data must be
independent. (Samuel Cameron, 2005)

Having 5 independent variables and the dependent variable expressed in percentages I did not
had to apply natural logarithm to eliminate issues which my appear due to different units of
measure.

Regression model specification

ER = B0 + B1TotInv + B2 Inflation + B3 Unempl + B4 ToTdiff + B5 GDPdiff + B6 rdiff + µ

Dependent variables:

Real effective Exchange rate (ER)

Independent variables:

1. Total Investment as a percentage of GDP (TotInv)

2. Inflation (Inflation)
3. Unemployment as a percentage of labour force (Unempl)
4. Terms of Trade differential (ToTdiff)
5. GDP per capita differential (GDPdiff)
6. 10-year Government bonds interest rate differential (rdiff)
A priori sign expectation:

B2 B3<0
B1 B4 B5 B6 >0

UB:11005648 Page 15
 Variable name Unit of measurement Unit of time Source
Total Investment as a Per cent Annual IMF Data and
percentage of GDP Statistics
(TotInv)
Inflation (Inflation) Per cent Annual IMF Data and
Statistics
Unemployment as a Per cent Annual IMF Data and
percentage of labour Statistics
force (Unempl)
Terms of trade Per cent Annual OECD Statistics
differential (ToTdiff)
GDP per capita Current US$ Annual OECD Statistics
differential
(GDPdiff)
10-year Government Per cent Annual OECD Statistics
bonds interest rate
differential (rdiff)
Real effective Per cent Annual IMF Data and
Exchange rate (ER) Statistics

I will try to accurately describe the behaviour of the exchange rate in the long-run with all
these variables. The aim of the dissertation is to construct a model which can predict the real
exchange rate in the long-run taking into account a variety of determinants. Furthermore I will
explain the reasoning behind my chosen variables. Due to multicolinearity problems public
debt and current account balance had to be removed.

Real effective Exchange rate (ER)

The real effective exchange rate (ER) is my dependent variable and is expressed in percentage
changes with 2005 as base year. The real effective exchange rate is adjusted for inflation and
is equal to the nominal effective exchange rate divided by the price index.

Total Investment as a percentage of GDP (TotInv)

The first independent variable is total investment as a percentage of GDP. According to

Ronald MacDonald (2004) this variable is an exchange rate determinant and is positively
related to the exchange rate. If the government increases spending this will eventually
increase interest rates, thus will make domestic deposits more attractive to foreigners. A
potential issue of this variable is the fact that it does not show the actual investment figure
because is expressed in percentages of GDP.

Inflation (Inflation)

The second variable is inflation, according to IMF Data and Statistics (2014) it reflects the
annual changes in the consumer price index or more specifically the changes in the cost of the
index basket of goods and services for the average consumer. According to Jason Van Bergen
(2010) inflation makes a currency riskier, thus reducing the demand for it. Also inflation
increases the price of exports; hence foreign consumers will decrease the demand.

UB:11005648 Page 16
Unemployment as a percentage of labour force (Unempl)

The third variable reflects the domestic unemployment. MacDonald R. et. all (1998) suggest
this variable as being part of the fundamental vector. According to economic theory
unemployment affect many variables from the economy, hence my desire to see its effects on
the exchange rate.

Terms of trade differential (ToTdiff)

The main issue which I immediately encountered with this variables was the lack of data, thus
I was forced to calculate the terms of trade for both UK and USA. I divided the value of
exports by the value of imports for both economies; to obtain a percentage like value I
multiplied the result by 100. Jorge Carrera (2008) sustain that terms of trade are positively
related to the exchange rate. To maintain this relationship I subtracted from USA terms of
trade the UK terms of trade, thus an increase in UK’s terms of trade is translated into an
increase in ToTdiff.

GDP per capita differential (GDPdiff)

According to IMF Data and Statistics (2014) GDP is the sum of gross value added by all
resident producers in the economy plus product taxes minus subsidies. GDP per capita is
obtained by dividing the GDP with the midyear population figure. To maintain the positive
relationship observed by MacDonald et. all (2007) I subtracted from USA GDP per capita the
GDP per capita from UK, hence an increase in UK GDP per capita ceteris paribus will
translate into an increase in GDPdiff.

10-year Government bonds interest rate differential (rdiff)

The last variable is the 10-year Government bonds interest rate differential. This variable is
sustained both by out theoretical section and the empirical one. Jason Van Bergen (2010)
argues that when the interest rate raises domestic deposits become more attractive, hence this
will make the exchange rate stronger. From the partner economy (USA) interest rate I
subtracted the UK interest rate, thus maintaining the expected positive relationship of rdiff
with the exchange rate.

UB:11005648 Page 17
5. Data Analysis

The Data analysis is divided into 3 sections. The first section explores the descriptive
statistics of our data. The second section tests for multicollinearity and autocorrelation and the
final section focuses on the regression results.

5.1 Descriptive statistics

In the first section of the analysis I will focus on the interpretation of the data or descriptive
statistics. The need of constructing a separate line chart for GDP per capita differential
appeared due to the major difference between the values of this variable and the values of the
rest. All 6 variables have a sample size (N) of 34 as can be seen in Fig. 3 (Descriptive
statistics) .

The first variable we focus on is total investment as a percentage of GDP, the mean in this
case is approximately 17.34 and the standard deviation is 1.72 which suggests that the values
are not so spread out. We observe 2 major spikes in the chart, a maximum of 21.99 in 1989
and a minimum of 14.07 in 2009. Apart from those 2 spikes the total investment as a
percentage of GDP is stable at a 17.34% per year for the period 1980-2013. The rise in total
investment in 1989 is prior to the 1990-1991 UK inflation related recession, hence after the
recession started we can see a 5-6% drop in the total investment. Also we observe the same
behaviour in the case of 2007 recession.

The second variable is inflation, which is represented by the green line. The standard
deviation is 3.32 which is higher than in the previous case suggesting a bigger spread of the
values. We observe a minimum of 0.78% in 2000 and a maximum of 16.84 in 1980 during the
oil price crisis. Another interesting observation is the difference in inflation rate between
1980-1981, 1990-1991 recessions and 2007 recession. According to this chart the 2007
recession is softer than the others in terms of inflation. The mean over this period is 3.95%
which is higher than the 2% inflation objective. However this objective has been met from
1994 until 2006 according to Fig. 1.

The third variable analyzed is unemployment which has a standard deviation of 2.19 and a
mean of 7.86%. In this case the maximum, 11.75% is recorded in 1984 and the minimum of
4.75% is reported in 2004. From Fig. 1 we can see a negative relationship between total
unemployment and total investment. When total investment decreases in periods of recession
1980-1981, 1990-1991 and 2007-2008 total unemployment increases. We also observe that
during 1996-2006 both inflation (2%) and unemployment (5%) were stable.

The forth variable is terms of trade differential. In this case the standard deviation is 7.56 and
the mean -16.58. The minimum of -32.39 is achieved in 1985 and the maximum of -1.42 is
reported in 1989. For this particular variable due to the way it was constructed the minimum
is disguised in maximum and vice-versa. The minimum value in fact represents the highest
difference in terms of trade between UK and USA, while the maximum represents the lowest
difference.

UB:11005648 Page 18
The fifth variable is 10-years government bonds interest rate differential. This variable has the
lowers standard deviation, only 0.98 and a mean of -0.75. The maximum is 1.31 and is
observed in 1984, while the minimum is -3.25 and is registered in 1990. We observe an
inverse relationship between terms of trade differential and interest rate differential. In 1984-
1985 terms of trade differential records its minimum value while interest rate differential
records its maximum value. This relationship is maintained in 1989-1990 when terms of trade
differential records its maximum value while interest rate differential records its minimum
value.

The last variable is GDP per capita differential with the largest standard deviation of 2656.97
and a mean of 7968.26. The maximum for this variable is recorded in 2012 and is equal to
12828.96 and the minimum is observed in 2007 and equals 1459.85. As we can see in Fig. 2
the GDP per capita differential increases during times of global recession, suggesting that the
UK economy is much more sensible to recessions than the USA economy.

30
UNITED KINGDOM

20

10

Total Investment
0 Inflation
80 82 8 4 8 6 8 8 9 0 92 9 4 9 6 9 8 0 0 0 2 0 4 0 6 0 8 1 0 1 2 Unemployment
1 9 1 9 19 19 19 19 1 9 19 19 19 20 20 20 20 20 20 20
Terms of Trade Differential
-10 Interest rate differential (10 years
Gov. Bonds)

-20

(OECD, 2014)
-30

-40 Fig. 1

UB:11005648 Page 19
 United Kingdom
14000
12000 GDP per capita
Differential
10000
8000
6000
4000
2000
(OECD,
0 2014)
80 98 3 986 98 9 99 2 995 99 8 001 004 00 7 010 01 3 Fig. 2
19 1 1 1 1 1 1 2 2 2 2 2

N Minimum Maximum Mean Std. Deviation

TotInv 34 14.0710 21.9940 17.336059 1.7189004

Inflation 34 .7850 16.8490 3.958971 3.3202450
Unempl 34 4.7500 11.7500 7.865059 2.1916855
ToTdiff 34 -32.3928 -1.4259 -16.581301 7.5629147
GDPdiff 34 1459.8536 12828.9611 7968.264362 2656.9752778
rdiff 34 -3.25 1.31 -.7524 .98786
Valid N (listwise) 34
Fig. 3

UB:11005648 Page 20
5.2 Multicollinearity and autocorrelation tests

The second section will test for multicollinearity and autocorrelation. In order to asses if there
is any linear relationship between the independent variables I will use the variance inflation
factor (VIF). Figure 4 shows that VIF values for each independent variable are between 1 and
2 which is below 10, the establish threshold value. This suggests that we do not face any
multicollinearity issues. Furthermore, another problem for time-series data is serial correlation
or autocorrelation. To test if the size of the residual for one case has no effect on the size of
the residual for the following case we implement the Durbin-Watson statistic. In our case the
value is 1.9 which is close to 2 indicating that our model does not have autocorrelation issues.

Durbin-Watson = 1.90

Variables Collinearity Statistics - VIF

Total investment as a percentage of GDP 1.156
Inflation 1.801
Unemployment percentage of total 1.330
unemployment
Terms of Trade differential 1.399
GDP per capita differential 1.712
10-year Government Bonds interest rate 1.752
differential
Fig. 4

UB:11005648 Page 21
5.3 Regression analysis

Dependent variable: ER Estimated coefficient p-value

B0 (constant) 115
TotInv -0.010 Not significant 0.984
(0.021)
Inflation 0.819*** 0.010
(2.771)
Unempl -2.210*** 0.001
(5.739)
ToTdiff -0.075 Not significant 0.518
(0.655)
GDPdiff -0.001*** 0.004
(3.151)
rdiff 3.657*** 0.001
(3.730)

R2 0.766
Adj. R2 0.714
F (6,27) 14.762*** 0.001
N 33

The third section focuses on the analysis of the regression result. Given the above coefficients
we can now substitute them into our model.

ER = B0 + B1TotInv + B2 Inflation + B3 Unempl + B4 ToTdiff + B5 GDPdiff + B6 rdiff + µ

ER= 115 – 0.01 TotInv + 0.819 Inflation – 2.210 Unempl – 0.075 ToTdiff – 0.001 GDPdiff
+3.657 rdiff + µ

A priori sign expectation:

B2 B3 <0
B1 B4 B5 B6 >0

Actual sign:

B1 B3 B4 B5 < 0

B2 B6 >0

Before proceeding to the actual analysis I will discuss the constant term and the µ or
disturbance term. Samuel Cameron (2005) argues that B0 is the intercept of the equation with
the axis OY, failure to include this in your model will make the sum of the residuals different
from 0 and thus the function line will go through the origin instead of going through the
mean. This implies that the model will suffer from bias and that our line is not the best fitting
line. The µ or disturbance term is a random number which embodies all specification errors.
This term allows the model to capture all omitted variables which influence the dependent
variable. Samuel Cameron (2005) argues that following specification errors are corrected by

UB:11005648 Page 22
adding the disturbance term: wrong choice of functional form, errors in the collection of the
data, the differences between variables and theoretical concepts and the fact that parameters
might change with time.

Furthermore, to analyze the coefficients of our independent variables I will implement the
three S method from Cameron (2005) for each one of my variables.

Sing/ Size/ Significance – 3 S

For Total investment as a percentage of GDP (TotInv) our predicted sign was positive but
after running the regression we observe a negative sign. This would suggest that there is a
negative relationship between the real effective exchange rate and the total investment as a
percentage of GDP. Looking at the size of the coefficient which equals -0.010 we can
conclude that a 1 unit change in total investment as a percentage of GDP will result in -0.010
units change in the real effective exchange rate. Lastly, the p-value is 0.984 which bigger than
0.05 the critical value suggesting that this variable is not significant for 95% confidence level.

In the case of Inflation (Inflation) the predicted relationship was negative according to the
empirical section but our regression gave a positive relationship. The size of the coefficient is
0.819 meaning that a 1 unit change in inflation will create a 0.819 units change in the real
effective exchange rate. The p-value is 0.010 which is equal to the critical value for the 99%
confidence; hence inflation is significant at 99% confidence level.

The third variable Unemployment as a percentage of labour force (Unempl) has a negative
sign which is in accordance with our earlier prediction. The size of the coefficient is -2.210
which implies that a 1 unit change in unemployment will result in -2.210 units change in the
real effective exchange rate. Because the p-value is 0.001 which is below 0.01 the critical
value for 99% confidence level we conclude that this variable is significant.

The forth variable Terms of trade differential (ToTdiff) had a positive sign predicted;
analyzing the results we observe that the actual sign in negative. The size of the coefficient is
-0.075 implying that a 1 unit change in terms of trade differential will cause a -0.075 units
change in the real effective exchange rate. In this case the p-value is 0.518 which is higher
than 0.05, this suggests that this variable is not significant at the 95% confidence level.

The fifth variable or GDP per capita differential (GDPdiff) has a negative sign and is not in
accordance with the predicted sign. This implies that for the UK economy an increase in GDP
per capita will translate in an increased demand for imports, thus making the exchange rate
weaker. The size of the coefficient is -0.001 meaning that a 1 unit change in GDP per capita
differential will cause a -0.001 units change in the real effective exchange rate. The p-value is
0.004 which is lower than 0.01, hence this variable is significant at 99% confidence level.

The last variable, Interest rate differential (rdiff) expresses a positive relationship with the
dependent variable which makes our prediction valid. The size of the coefficient is 3.657; this
implies that a 1 unit change in interest rate differential will translate into a 3.657 units change
in the dependent variable. The p-value is equal to 0.001 making this variable significant at
99% confidence level.

Other 2 values which need to be analyzed are the R squared statistic and the F statistic. R
squared statistic explains the variation of Y around its mean (Cameron, 2005). In our case R

UB:11005648 Page 23
squared statistic is equal to 0.766, this means that 76.6% of the variation in the real effective
exchange rate is explained by our variables, thus our model has a good fit. The F statistic
measures the significance of the whole model and is equal to 14.762. By comparing our p-
value with the critical p-value we can analyze if our model is significant or not. In our case p-
value is equal to 0.001 making our model significant at 99% confidence level. The two values
6 and 27 from within the brackets represent the degree of freedom and the number of
variables.

K=6

Df= N-K-1=34-6-1=27

UB:11005648 Page 24
6. Limitations & Further Research

This section will focus on the limitations of the model and will suggest further research
hypotheses.

The first limitation of this model is the use of a simple OLS regression which only allows to
observe linear relationships. Using this type of test with variables which do not have a linear
relationship with the real effective exchange rate will not provide credible results. The two
insignificant variables, total investment as a percentage of GDP and terms of trade differential
might be determinants of our dependent variable but because their relationship is not linear
the OLS regression results presents them as insignificant. According to the empirical section
terms of trade differential should be a major determinant of the real effective exchange rate
but our model fails to observe this. Furthermore, another possible cause for this could be the
sample size; although it is higher than 30, the minimum required, Samuel Cameron (2005)
argues that by increasing the sample size our regression becomes more stable and less
sensible to outliers.

As observed above the signs of some of the independent variables are not the same as the ones
predicted in the methodology section. This could be explained through the differences in the
economies analyzed. Because each economy is unique, the relationships observed on one
economy cannot be taken as 100% certain for all economies.

Further developments of the model can be made by increasing the sample size, changing the
collection interval i.e. semi-annual, quarterly and by analyzing multiple economies and
comparing the results. Also the regression model can be change from linear to Log-linear,
Linear-log or double-log.

Suggested models:

Linear

ER = B0 + B1TotInv + B2 Inflation + B3 Unempl + B4 ToTdiff + B5 GDPdiff + B6 rdiff + µ

Log-linear

LnER = B0 + B1TotInv + B2 Inflation + B3 Unempl + B4 ToTdiff + B5 GDPdiff + B6 rdiff + µ

Linear-log

ER = B0 + B1 LnTotInv + B2 LnInflation + B3 LnUnempl + B4 LnToTdiff + B5 LnGDPdiff +

B6 Lnrdiff + µ

Double log

LnER = B0 + B1 LnTotInv + B2 LnInflation + B3 LnUnempl + B4 LnToTdiff + B5 LnGDPdiff

+ B6 Lnrdiff + µ

According to Michael Hauser (2014) more advanced tests such as Cointegrated VAR models
are more suitable to analyze the determinants of the real effective exchange rate. This type of

UB:11005648 Page 25
analysis can be incorporated in future papers to achieve a more complex and complete
interpretation of the relationship between the independent variables and the dependent
variable. Lastly, as specified in the methodology section public debt and current account
balance were taken out due to multicollinearity problems, these variables can be added in
VAR models without facing any multicollinearity issues.

UB:11005648 Page 26
7.Conclusion

To conclude, this paper focused on the determinants of the real effective exchange rate. The
five main chapters are: the Theoretical Framework, the Empirical Literature review,
Methodology, Data Analysis and Further Research/Limitations.

The Theoretical Framework is divided into 3 sections, the first section analyzed the PPP
theory because as Abuaf N. And P. Jorion (1990) argued this is the starting point for every
exchange rate determination model. The Law of One Price (LOOP) is discussed and
translated into absolute and relative PPP. Furthermore, due to the drawbacks of the PPP
theory and its non realistic assumptions we abandon this simplistic theory which served its
purpose of giving us a greater understanding of the exchange rate determination. The second
section of the Theoretical Framework looks at the Fundamental Equilibrium Exchange Rates
theory. MacDonald R. et. all (1998) sustains that FEER does not incorporate a theory of
exchange rate determination, in addition to this drawback the estimation of the potential
output for both the domestic and foreign economy might prove to be too complicated, thus a
better method has to be used to analyze the determinants of the ER. The final section
introduces the Behavioural Equilibrium Exchange Rate or BEER which according to
MacDonald R. et. all (1998) is a more complete model for exchange rate determination.

The Empirical/ Contextual Literature review focused on journals which used PPP, FEER and
BEER as methods of exchange rate determination. These journals gave me an insight into the
advantages and drawbacks of each theory and also helped me to form my predictions for each
independent variable used.

Methodology gave an overview of my independent variables: Total investment as a

percentage of GDP, Inflation, Unemployment as a percentage of total labour force, Terms of
trade differential, GDP per capita differential and 10-years Government bonds interest rate
differential and presented the advantages and disadvantages of the OLS regression.

The Data analysis chapter covers descriptive statistics, multicollinearity test, autocorrelation
test and the regression analysis. In the descriptive statistics we observe an inverse relationship
between total investment and unemployment. Furthermore, our model passes the
multicollinearity and autocorrelation tests but the Public Debt and Current Account Balance
variables have to be removed. The final section argues that Total Investment as a percentage
of GDP and Terms of Trade differentials are insignificant while Inflation, Unemployment,
GDP differentials and interest rate differentials are significant at 99% confidence level.

The final chapter, Limitations and Further research debates possible reasons for the
insignificance of the Total investment as a percentage of GDP and Terms of Trade
differentials and suggests further improvements and research hypotheses.

UB:11005648 Page 27
Reference list

 Abdalrahman et all. (2009). The Determinants of Exchange rate on Asean-5 countries:

An Evidence on Purchasing power parity. Available at:
http://papers.ssrn.com.ezproxy.brad.ac.uk/sol3/papers.cfm?abstract_id=1278784
[Accessed: 14 April 2013]
 Anders Bergvall (2002). What Determines Real Exchange Rates? The Nordic
countries. Available at:
http://www.diva-portal.org/smash/get/diva2:129240/FULLTEXT01.pdf [Accessed:
11.11.2013]
 Anwar Shaikh and Rania Antonopoulos (1998). Explaining Long Term Exchange rate
Behavior in the United States and Japan. Available at:
http://www.levyinstitute.org/pubs/wp250.pdf [Accessed: 10.11.2013]
 Baimbridge M. (2000). The impact of the Euro: Debating Britain’s Future.
Houndmills: Palgrave Macmillan
 Balazs Egert et. all (2002). The Balassa-Samuelson Effect in Central and Eastern
Europe: Myth or Reality?. Available at:
http://pocarisweat.umdl.umich.edu/bitstream/handle/2027.42/39868/wp483.pdf?
sequence=3 [Accessed: 12.11.2013]
 Cameron, S. (2005). Econometrics. United Kingdom: McGraw-Hill Education.
 Devereux M. B. (1997). Real Exchange Rates and Macroeconomics: Evidence and
Theory. Canadian Journal of Economics, No. 4a. Avaialable at:
http://www3.nd.edu/~nmark/gradinter_files/Devereux%20Macroeconomics%20and
%20Exchange%20Rates.pdf [Accessed: 17.03.2014]
 Ehsan U. Choudhri and Mohsin S. Khan (2004). Real Exchange Rates in Developing
countries: Are Balassa-Samuelson Effects Present? Available at:
http://www.imf.org/external/pubs/cat/longres.aspx?sk=17741.0 [Accessed:
11.11.2013]
 Hamid Faruqee (1995). Long-Run Determinants of the Real Exchange Rate: A stock-
Flow Perspective. Available at: http://books.google.ro/books?
id=WWqvPfjV2ZQC&printsec=frontcover&dq=Faruqee+Long-
Run+Determinants+of+the+Real+Exchange+Rate&hl=en&sa=X&ei=P7SgUqWbH6Gp7
QbVh4G4Aw&ved=0CC0Q6AEwAA#v=onepage&q=Faruqee%20Long-Run
%20Determinants%20of%20the%20Real%20Exchange%20Rate&f=false [Accessed:
11.11.2013]
 Imed Drine and Christophe Rault (2003). On the long-run determinants of real
exchange rates for developing countries: Evidence from Africa, Latin America and
Asia. Available at: http://deepblue.lib.umich.edu/handle/2027.42/39957 [Accessed: 14
April 2013]
 IMF Data and Statistics (2014). Available at: https://www.imf.org/external/data.htm
[Accessed: 17.03.2014]
 Jason Van Bergen (2010). 6 Factors that influence exchange rates. Available at:
http://www.investopedia.com/articles/basics/04/050704.asp [Accessed: 20.04.2014]

UB:11005648 Page 28
  Jorge Eduardo Carrera. (2008). Long Run Determinants of Real Exchange Rates in
Latin America. Available at: http://papers.ssrn.com/sol3/papers.cfm?
abstract_id=1127121 [Accessed: 12 April 2013]
 K. Pilbeam (1992). International Finance. Basingstoke: Macmillan
 Kenneth Rogoff et. all (1994). Perspectives on PPP and Long-Run Real Exchange
Rates. Available at: http://www.nber.org/papers/w4952 [Accessed: 12.11.2013]
 Krugman, P. (2012). International Economics. 9th Ed. Boston London: Pearson
Education Limited.
 Krugman, P. R. et. all (2012). International economics: theory and policy. Harlow:
Pearson Education.
 Laurence S. Copeland (1994). Exchange Rates and International Finance. Addison
Wesley Longman Limited.
 Menzie Chinn and Louis Johnston (1997). Real Exchange Rate Leves, Productivity
and Demand Shocks: Evidence from a Panel of 14 countries. Available at:
http://www.imf.org/external/pubs/ft/wp/wp9766.pdf [Accessed: 12.11.2013]
 Mishkin, F. S. (2012). Macroeconomics: policy and practice. Harlow: Pearson
Education.
 Niso Abuaf and Philippe Jorion (1990). Purchasing Power Parity in the Long Run.
Available at:
http://newdoc.nccu.edu.tw/teasyllabus/107160357030/ppp_aj_jf90.pdf [Accessed:
11.11.2013]
 OECD Statistics (2014). Available at: http://stats.oecd.org/ [Accessed: 17.03.2014]
 Peter B. Clark and Ronald MacDonald (1998). Exchange Rates and Economic
Fundamentals: A Methodological comparison of BEERs and FEERs. Available at:
http://www.imf.org/external/pubs/ft/wp/wp9867.pdf [Accessed: 11.11.2013]
 Ronald MacDonald (1997). What Determines Real Exchange Rates? The Long and
Short of It. Available at: http://www.imf.org/external/pubs/ft/wp/wp9721.pdf
[Accessed: 12.11.2013]
 Ronald MacDonald (2004). The Long-Run Real effective exchange rate of Singapore:
A Behavioural approach. Available at:
http://www.mas.gov.sg/~/media/resource/publications/staff_papers/StaffPaper36Re
erMcDonald.pdf [Accessed: 10.11.2013]
 Ronald MacDonald and Preethike Dias (2007). Behavioural equilibrium exchange
rate estimates and implied exchange rate adjustments for ten countries. Available at:
http://www.iie.com/publications/pb/pb07-4/macdonald.pdf [Accessed: 10.11.2013]

Bibliography

 Anders Bergvall (2002). What Determines Real Exchange Rates? The Nordic
Countries. Available at:
http://www.diva-portal.org/smash/get/diva2:129240/FULLTEXT01.pdf [Accessed:
12.11.2013]

UB:11005648 Page 29
  Anwar M. Shaikh and Rania Antonopoulos (1998). Explaining Long-term Exchange
Rate Behavior in the United States and Japan. Available at:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=132508 [Accessed: 17.03.2014]
 Frederic, S. Mishkin (2012). Macroeconomics: Policy and Practice. United Kingdom:
Pearson Education Limited.
 Hsiu-Ling Wu (1996). Testing for the Fundamental Determinants of the Long-Run
Real Exchange Rate: The case of Taiwan. Available at:
http://www.nber.org/papers/w5787 [Accessed: 12.11.2013]
 Kees Koedijk (1990). What Do we know about the Long-Run Real Exchange rate?.
Available at:
http://research.stlouisfed.org/publications/review/90/01/LongRun_Jan_Feb1990.pdf
[Accessed: 17.03.2014]
 Kenneth A. Froot et. all (1996). Perspectives on PPP and Long-Run Real Exchange
Rates. Available at: http://www.nber.org/papers/w4952 [Accessed: 12.11.2013]

UB:11005648 Page 30