Determinants of exchange rates and foreign exchange volatility

Abstract

Explaining the movements in the exchange rate is still a puzzle to economists particularly since the break down of the Bretton Wood system in the early 1970's, when many countries introduced a floating system. This paper tries to deepen our understanding of this puzzle by using a model that makes use of data from Singapore, the UK and Kenya. The period covered is January 1993 and December 2008. The variables in the model money supply, current account balance, capital account balance, official reserves balance,interest rate and inflation differential. The dependent variable is exchange rate. The model has purchasing power parity and uncovered interest parity as underlying theoretical assumptions, two main building blocks of open macro economics. A linear regression model was used to analyze the data. In addition Cointergration and Granger-Simms causality tests were used to gain further insights into the research problem. The results show that most of the variables have an inverse relationship with the exchange rate. In emerging and developing countries (Singapore and Kenya) it is the exchange rate which influence the movement of economic fundamentals in question and not the other way round, although interest rate differential constitutes a significant explanatory variable for exchange rate movements in all the three countries included in the model. Both Singapore and the UK have also, in accordance with the RID model, the expected negative sign on the coefficient. The results regarding the other variables are mixed among the countries.