Factors that determine nominal exchange rates and empirical evidence of cross-sectional analysis

Transcription

1 MSc in Finance and International Business Author: Bahodirjon Boykorayev Academic advisor: Associate Professor Erik Strøjer Madsen Factors that determine nominal exchange rates and empirical evidence of cross-sectional analysis Aarhus School of Business August 2008

2 Abstract While there has been voluminous research on the determinants of exchange rates for developed and developing countries, majority of works, considering selected issues theory of exchange rates, is quite fragmented. This paper combines many factors forming the exchange rate and the factors of choice of exchange rate regime in small open economies. The present research work examines determinants of Nominal and Real exchange rates for the period This thesis addresses the basic theory of the exchange rate, which emphasizes the influence of various factors on its dynamics, as well as - the possibility of building a universal theory that would be correct for most countries and with different economic conditions. It was found that model is not applicable in the same conditions, as the significance of factors is changing as targeted country groups changed. Empirical evidence show that significance of factors in the model has changed in comparison to prior research papers. Keywords: Nominal exchange rate, Real exchange rate, Inflation, Floating exchange rates, Fixed exchange rate, Optimal exchange rate regime. 1

3 Table of Contents INTRODUCTION THEORY OF THE EXCHANGE RATE Essence of the exchange rate, types and functions The theory of purchasing power parity Factors affecting the value of the exchange rate Best national monetary system and optimal exchange rates Fixed Exchange Rates Free-Floating Exchange Rate Advantages and disadvantages of alternative exchange rate regimes LITERATURE REVIEW EMPIRICAL ANALYSIS Data Description and Methodology Empirical Analysis Interpretation Of Results CONCLUSION APPENDIX BIBLIOGRAPHY

4 INTRODUCTION In recent decades, it is observed a rapid development of global capital market and financial services. In these circumstances, the dynamics of exchange rates have an increasing impact on the overall macroeconomic situation in countries around the world. This applies particularly to small open economies, where domestic monetary policies don t have an impact on world interest rates. For these countries, the exchange rate becomes a major tool to adapt to changing external conditions. Currency crises in Latin America, South-East Asia and other selected countries have shown that the imbalance of monetary policy can lead to serious consequences for the entire financial system of countries, and in a high degree of capital mobility - and to systemic crises worldwide. Therefore, identification and analysis of the factors determinants exchange rates the theoretical task, which has a great practical significance. The theories of the exchange rate began to grow in the beginning of 1960s. Few years later, the works related to the theoretical methods applied in monetary policy appeared. It should be noted considerable diversity theories of exchange rates, which have been developed to date. However, the analysis shows that the majority of works, considering selected issues theory of exchange rates, is quite fragmented. There are few works carried out, conducting a comprehensive analysis of the factors forming the exchange rate and the factors of choice of exchange rate regime in small open economies. This thesis will address the basic theory of the exchange rate, which emphasizes the influence of various factors on its dynamics, as well as - the possibility of building a universal theory that would be correct for most countries and with different economic conditions. In 1971, it ceased to operate the Bretton Woods system of fixed exchange rate. And since 1978, operates so-called Jamaica monetary system. The basic principles of this system are that, the countries have their own choice to any system of the exchange 3

5 rate - fixed or floating, established unilaterally or through multilateral agreements. As a result, the dynamics of the exchange rate has become to provide greater influence on the overall macroeconomic situation than it was before. The successful outcomes of policies and practices of floating exchange rate is that the mechanism of this type is most suited to modern principles of openness of national economies and their integration with the world economy. In turn, the system of fixed parities forcing the country to hold the exchange rate at a certain level, which may hinder the direct effect of external factors on the domestic economy. It conserves the structure and proportions, which are no longer relevant for changed international conditions of production and exchange. The purpose of the thesis is to determine the factors affecting the dynamics of the exchange rate and the choice of exchange rate regime. To achieve the desired objective study identified the following tasks: - Analyzing the content and the evolution of theoretical approaches to determining the factors forming the exchange rates; - Develop a methodology for determining the factors forming the exchange rates; - Determine the composition of the factors affecting the dynamics of the exchange rate and the choice of exchange rate regime; direction of these factors; - Identify and justify the difference in determining the factors forming the exchange rate between developed, developing countries and countries with economies in transition; - Examine methods of monetary policy in different countries in terms of matching official and the real objectives of monetary policy. Theoretical and methodological foundation served as a design study of scientists in the field theories exchange rate, methodological recommendations of international financial organizations. In his study I relied on primary sources - monographs and 4

6 articles of recognized experts in the field of economic theory of exchange rates and inflation. For statistical model I use nominal exchange rate as an equation of inflation differential and real exchange rate. For the empirical part Regression analysis is chosen. To maintain the power of the model and preciseness of the determinants OLS method is applied. Theoretical fundaments will base on Purchasing Power Parity (PPP) for national currencies and Barro-Gordon policy for long run inflation rates. The research paper starts with introduction and follows by theoretical base. Literature review is submitted in the next chapter. The following chapter covers Model, Data description and methodology. Empirical analysis of cross-sectional data is viewed at the end of the third chapter. Conclusion of the research is given afterwards. Then follow references and appendices. 5

7 1. THEORY OF THE EXCHANGE RATE 1.1. Essence of the exchange rate, types and functions Each country has a currency in which the prices of goods and services are quoted the dollar in the USA, the euro in France, the pound sterling in the UK, the yen in Japan, and the kroner in Denmark and hundreds in a line. Exchange rates play a central role in international trade because they allow us to compare the prices of goods and services produced in different countries. In daily newspapers you can see relative prices of national currency per foreign unit. Weekly or monthly magazines and journals show growth trends over specific period. As long as exchange rates are part of our everyday business or main factor that effect the way how our business goes, it is worth to analyze how currency rates change and what are the determinants that control this movement. One of the major elements of monetary system of a country is the exchange rate, where the exchange value of national currency of one country expressed in monetary units of another country. The studies on exchange rates and possible variations of currency rates attracted great interest in 70s; and so far this topic one of the leading ones in economic sphere. The scholars have presented several types of exchange rates. But I will follow most common types which are practiced in IMF staff papers. This classification system is based on scholars researches, names may be different in official arrangements. The order of exchange rate arrangements is on the basis of their degree of flexibility and the existence of commitments to exchange rate paths (IMF International Financial Statistics). 1. Exchange arrangements with no separate legal tender 2. Currency board arrangements 3. Conventional fixed peg arrangements 4. Pegged exchange rates within horizontal bands 5. Crawling pegs 6. Exchange rates within crawling bands 7. Managed floating with no predetermined path for the exchange rate 8. Independently floating 6

8 For full description and country classification by exchange rata regimes see appendix. For the ease of usage I rename most used ones as free floating, managed floating and fixed exchange rate regimes. In free floating system the exchange rate is formed under the influence of the market demand and supply and may vary significantly in size. The size of the demand for foreign exchange is determined by the needs of the country in imports of goods and services, tourist spending in the country, demand for foreign financial assets and demand for foreign currency in connection with the intentions of residents to invest abroad (Deverux and Engel 1998). In managed floating system, besides supply and demand, the central banks of the country have a strong impact on value of exchange rate, as well as various temporary market distortions. A fixed exchange rate or pegged exchange rate is a type of exchange rate regime where a currency's value is matched to the value of another single currency or to a basket of other currencies like SDR, or to another measure of value, such as gold. As the reference value rises and falls, so does the currency pegged to it (Krugman & Obstfeld, International Economics). In addition, countries with fixed exchange rates lose control over independent domestic monetary policy to achieve internal stability. Fixed exchange rate fluctuates within the narrow framework. An example of the fixed rates system is the Bretton-Woods currency system ( ). Gold-dollar standard established at Bretton Woods in reality functioned on a dollar basis, since only the U.S. tried to maintain direct convertibility of their currencies into gold. The basic idea of Bretton Woods agreement was to guarantee freedom of payments, particularly in barter. One of the most important concepts used in the foreign exchange market, is the notion of real and nominal exchange rate. The real exchange rate can be defined as the ratio of prices of goods the two countries made in the respective currency. The nominal exchange rate shows the rate of exchange rates, operating in the present moment in the foreign exchange market (Krugman & Obstfeld, International Economics). 7

9 The rate of the national currency may vary differently towards different currencies over time. Thus, in relation to strong currencies, it can fall, but against the weakest - rise. That is why exchange rate index is calculated to determine the full dynamics of the currency. Exchange rates help to stabilize external relations of the economy and maintain fair trade. However, any type of currency regimes has similar purposes (Bilson & Marton 1984). The main functions of exchange rates: Mutual exchange of currencies for trade in goods, services, within loans and capital movements. Exporter exchanges earned foreign currency on the national, as the currency of other countries cannot be circulated as a legal means of circulation for purchasing and payments on the territory of the country. Importer exchanges foreign currency to pay for goods purchased abroad. The debtor buys foreign currency for national currency write off debt payments and interest payments on foreign loans; Comparison of prices of world and national markets, as well as the to assess economic indicators in different countries, expressed in national or foreign currencies; Periodic reassessment of euro-currency accounts in companies and banks The theory of purchasing power parity. According to Purchasing Power Parity theory, in the long run, identical products and services in different countries should cost the same in different countries. This is based on the principle that exchange rates will adjust to eliminate the arbitrage opportunity of buying goods or services in one country and selling it in another. For example, take a cell phone that costs 2000 DKK in Denmark and an exchange rate of 5 Kroner to 1 USD. If the same phone costs 500 dollars in the USA, American consumers would buy the cell phone in Denmark. If done on a large scale, the inflow of U.S. dollars would drive up the price of the DKK, until it equalized at 4 Danish Kroner to 1 USD - the same ratio of the price of the cell phone in Denmark to the price of the phone in the U.S. The theory only holds for tradable goods, not to immobile goods or local services. The theory also ignores several real world factors, 8

10 such as transportation costs, tariffs and transaction costs. The other assumption is existence of competitive markets for the goods and services in both countries. The purchasing power parity (PPP) exchange rate is the exchange rate between two currencies that would equate the two relevant national price levels if quoted in one currency at that rate, so that the purchasing power of a unit of one currency would be the same in both countries. This concept of PPP is often termed absolute PPP. Relative PPP holds when the rate of depreciation of one currency relative to another equals the difference in aggregate price inflation between the two countries concerned. If the nominal exchange rate is defined simply as the price of one currency in terms of another, then the real exchange rate is the nominal exchange rate adjusted for relative national price level differences. When PPP holds, the real exchange rate is a constant, so that movements in the real exchange rate represent deviations from PPP (Sarno and Taylor, 2002). Purchasing power parity (PPP) is the cost base of exchange rate. Purchasing power evaluates the national average price levels for goods, services and investments. Under the free exchange of banknotes into gold, silver or other valuable metals and assuming the freedom of gold trade between the countries, the exchange rate slightly deviates from the PPP due to operation of gold mining and availability of underground wells Factors affecting the value of the exchange rate Like any price, exchange rate deviates from the valuation basis - the purchasing power of currencies - under the influence of demand and supply of currency. The correlation of such supply and demand depends on several factors. Multiple factor exchange rate reflects its relationship with other economic categories - cost, price, money, interest, the balance of payments, etc. In this paper I have selected several factors that I found significant in changes of exchange rates. They are GDP growth, inflation, country size, openness ratio, terms of trade, Central bank independence and government debt variables. Detailed information for each of variables is presented in data description and empirical part. 9

11 1.4 Best national monetary system and optimal exchange rates Areas of government exchange controls (NB, the Ministry of Finance, etc.) are determined on the basis of the criteria for best national monetary system. To select the optimal exchange rate regime and an effective system of currency regulation should be: defined the criteria optimal elements of national monetary system, considered the features of different types of currency regimes for use in the country clarified existing principles of currency regulation policy-making mechanism The currency regime is a set of forms and methods used in setting the exchange rate. The main objective of any exchange rate regime, is to protect the external competitiveness of the economy by strengthening balance of payments and stabilizing production (Deverux & Engel 1998). In the economies in transition countries the exchange rate does an important function. It is used to remove distortions in the structure of relative prices of goods and services, remained from the previous state of the economic system in which pricing was not in the light of market mechanisms. In market-oriented economy, manufacturers of exported goods adjust their production under world prices, after which happens adjustment of relative prices of non exporting goods. In the result, the national economy is integrating into the global structure of relative prices. In selecting the exchange rate system (currency regime) government usually guided by the following criteria: -- The current level of competitiveness of the economy; -- The balance of payments and financial system; -- State foreign exchange reserves; -- Economic and political climate in the country, etc. 10

12 When choosing a system of exchange rate, the Central Bank actually makes the choice between regulation of trust units, which can be identified - domestic credit, balance of payments deficit, international reserves and external debt. The main criterion of the optimal exchange rate regime and exchange control mechanism can be defined as minimizing the deviation of real production volumes of the national economy in case of crisis, arising from the external and internal factors of production volumes in times of economic recovery (Richard Cooper 1999). Historically, cash flows are classified as current accounts and capital flows in Balance of Payments. The results of this direction of currency regulation aimed to finding additional sources of financing of foreign trade imbalances and create conditions for their elimination: -- The implementation of direction of currency regulation is defined by IMF experts, as the use of legislative intervention mechanisms; -- The implementation of economical mechanism is defined as the implementation of operations in the "open market". There are two main foundations of monetary exchange rate regimes in the world practice. Stabilization of the economy can be carried out through one of these regimes: 1) A mechanism of fixing or pegging the national currency exchange rate against another currency or basket of currencies; 2) Regime, opposite to the first, based on freely floated currency exchange rates. Implementation of the explicitly defined instrument for currency regulation, one of the two currency regimes in a particular country does not happen, because it does not give the positive effect for the national characteristics of the given economic instrument. However, flexible currency regimes, such as "managed" or "pegged to 11

13 several currencies", are gaining an increasing popularity in many countries (Obstfeld & Rogoff 1995). The evolution of currency regimes in the world practice shows a trend of gradual transition from fixed exchange rate regimes to the more flexible exchange rate regime. The core mechanism of currencies with flexible exchange regimes is a real demand and supply of the national currency in the domestic and foreign markets. 1.5 Fixed Exchange Rates In fixed exchange rate system central bank sets the exchange rate at a certain level in relation to the currency of any country which its currency or the currency basket is "tied" with. The peculiarity of the fixed rate is that, it remains unchanged for long time (several years or several months), i.e. it does not depend on changes in supply and demand in the currency. Changing a fixed rate occurs as a result of its formal revision (devaluation or revaluation) by central bank (Edwards & Losada 1994). With a fixed rate the central bank often sets the various rates on individual transactions. Fixed exchange rate s system has the following advantages: - Quantitatively predictable (promotes trade and stimulates the flow of capital); - increases high confidence in the monetary policy, decreases government expenses spent to control inflation; - stabilized inflation, reduces inflationary expectations in the labour market and financial markets. However, this system is not without shortcomings. Country is not able to resist certain economic shocks resulting from loss of export markets and insufficiency of foreign exchange reserves to support the fixed rate. Typically, these phenomena are 12

14 accompanied by a sharp decline in domestic prices, which predefine recession and rising unemployment (Frenkel 1999). When setting a fixed rate system there is a problem of clarifying the correct price of currencies, but in case of pegging to one currency, the country is characterized by the following: - This policy is easily manageable by all companies in financial markets within the country; - The possibility of government manipulation of exchange rates is significantly reduced; - The risk of exchange rate in trade is reduced if partners trade in one currency, and favorable for the major trading partners; - The fluctuation of exchange rate of any currency foretells the change of the exchange rate against all other foreign currencies. Other advantage of the following system is that exchange rate fluctuations are much less, if the currencies in the basket are equally weighted. Fixed rates are committing financial regulatory organizations for a more strict monetary policy and price discipline, which helps rapidly to reduce inflation to lower losses for the economy. Fixation of exchange rate in the medium term can help to limit inflation costs in the economy under the influence of imports. With fixed exchange rates and mobile capital, the Central Bank cannot simultaneously regulate the supply of money and exchange rate, as market agents have the opportunity to convert the national currency into foreign assets. The monetary expansion lowers interest rates, and capital move abroad. With the substantial increase in money supply, fixed exchange rate, as the depletion of foreign reserves, will be under high pressure. The central bank will be forced to take action to tighten monetary regulation and to raise short-term interest rates on deposits to retain a fixed exchange rate level (Frenkel 1999). 13

15 Keeping the fixed exchange rate becomes quite problematic. The Central Bank may try to eliminate the impact of changes in foreign exchange reserves on money supply through a devaluation of the exchange rate. If such adjustments are not made, the exchange rate can potentially suffer even greater pressure. As international experience has shown, fixed exchange rate operates best in the country with the following conditions in the economy: - A small and open economy under the influence of a strong currency (or currencies of major trading partners); - A significant portion of foreign trade is carried out with a country whose currency is pegged to the national currency (for a stable trade environment for domestic producers); - Macroeconomic policies oriented at keeping the inflation at the level of the country, which currency attached to (in case of low rate of inflation); - Structural reforms are being implemented in the country, and there is a real independence of the Central Bank. However, fixed exchange rate without a tangible reforms cannot ensure long-term macroeconomic stabilization. Therefore, with implementation of a fixed rate, the Government needs to balance the macroeconomic indicators such as the money supply, the volume of goods and services and prices. It is very important to prevent the growth of nominal wages; otherwise it will eat the profit growth of enterprisesexporters, who are unable to raise their prices accordingly because of the need to remain competitive in the global market (Bubula & Ötker-Robe 2002). Thus, when using the fixed exchange rate, the country requires substantial foreign reserves to gain and then maintain confidence in the national currency, as well as ensuring full convertibility of national currency into foreign currency. Fixed exchange rate is effective: 1. when central regulatory bodies have substantial reserves of foreign currency; 2. if there is no sudden price shocks; 3. in the case of pegging to a basket of currencies. 14

16 In economy of transition countries, the use of the nominal exchange rate is limited to the fact that inflation in these countries is not only monetary origin, but also linked to the deformation of the pricing mechanism, a strong monopoly in the economy and default in payments. Fixed exchange rate is usually not effective on crisis of balance of payments because of the inevitability of macroeconomic adjustments. When exchange rate is fixed, the effectiveness of fiscal policy relatively higher than monetary. Because the entire effect of changes in the money supply is spent for maintaining the exchange rate and does not affect the levels of employment and production. 1.6 Free-Floating Exchange Rate The regime of free floating exchange rate takes into account the ratio of supply and demand in the national currency. In the absence of sufficient reserves for interventions, in order to maintain the announced target exchange rate level, the most acceptable option for the Central Bank turns to be free-floating exchange rate regime. However, the implementation of such a decision deters from the need of frequent changes in the exchange rate. Public authorities of monetary regulation are disabled to allocate the foreign currency with legislative process (Deverux & Engel 1998). In free-floating exchange rate regime occurs frequently changing of exchange rate under the influence of real demand and supply for foreign currency on the domestic and foreign currency markets. The central bank usually follows the exchange rate and determines its impact on domestic price changes. In economy of transition countries, there arises a situation where domestic prices are targeted to the exchange rate. In industrialized countries, the exchange rate depends on the price level. The Central Bank can influence the dynamics of the exchange rate by changing the interest rate. Successful implementation of free-floating exchange-rate regime requires less foreign reserves than in fixed exchange rate regime. Flexible exchange rates more favorable for countries with a stable and planned monetary and fiscal policies. 15

17 Eliminating the instability of economic policy as a source of internal instability, means that the greatest influence will provide foreign trade sector, flexible exchange rates help to overcome their negative effect with the least losses for the economy. If the economy of the country is widely diversified, the price elasticity of demand will be quite high, and floating exchange rate system will be able to function smoothly and more effectively respond to the needs of domestic regulation, as well as external (Backetti, Hakkio & Jones 1995). The more open economic system, the stronger the effect of exchange-rate on stability in the relative prices in local currency and resource allocation. Mechanism of floating exchange rates is divided into "clean floating and dirty floating. Clean floating - central bank does not intervene in the foreign exchange market. Dirty floating - there is periodically intervention in the foreign exchange market. This exchange rate allows you to maintain competitiveness and quickly adapts to external shocks and impulses, and the most important - the Government is relieved of the functions of determining an appropriate exchange rate. Despite these advantages, the regime of free floating exchange rate is not without flaws: - if the foreign exchange market is characterized by low capacity, then some few large transactions can undermine existing state; - this regime can ensure the effectiveness of monetary policy in regulation by the state, as well as taking financial and fiscal measures; - it can be unattractive to foreign investors and trading partners because of uncertainty in this regime; - There is a threat to government manipulation ( dirty floating ), thus undermining the credibility of market agents - if there is large speculative capital flows in the country, the determination of exchange rates greatly limits the monetary and financial independence. 16

18 Employment of the regime is most effective in the case of weak development of international commercial relations, i.e. when the volume of production is not heavily dependent on foreign trade (Frenkel 1999). Main conditions for implementation the floating exchange rates are existence of developed financial market, integration with the international system, the interchangeability of domestic and foreign monetary assets. Nevertheless, despite the absence of these factors, many countries have shifted to a floating rate regime. The reasons for this are imbalances in balance of payments, minor amounts of official foreign exchange reserves to support the fixed rate and desire to block the "black" exchange markets. First, industrially developed countries shifted to this system and then developing countries followed. But implementation the floating-rate of national currencies occurred within the limits of stabilization programs of IMF and availability of technical assistance; this caused a need for a set of economic measures such as economic restructuring, the liberalization of monitory and customs regimes, limiting demand, etc. In case of lack of these prerequisites, many countries are using a combination of fixed and floating rates. The main idea of this kind of crawling pegs is to conduct small-scale and partial currency exchange adjustments that are repeated once or twice a month (Dunn & Mutti, International Economics). The following attributes of crawling are pros to mention: - preliminary announcement rate of crawling, which increases the confidence of exporters and potential investors; - the possibility of maintaining actual fixed exchange rate. For example, when domestic inflation is 10% per year and inflation of the trading partner is 5% annual, the rate of creeping is set in the 5% depreciation per year. Cons of crawling peg rate are followings: - optimal exchange rate can vary over time, causing a constant need to adjust the rate of crawling in order to avoid destabilization of the economy; - regime could lead to higher inflation than in the fixed exchange rate. 17

19 Currency regime, based on a floating exchange rate is most effective: - In countries with stable economies with multilateral foreign trade relations and predictable fiscal and monetary policies; - In case of hyperinflation; - In a system of managed floating; - For regulation the balance of payments crisis. Choosing the free-floating rate eliminates the problem of determining the level of the national currency exchange rate, because the problem of determining the value of the currency is solved at the market. The benefit of such a regime is also the fact that, in such a situation there is no problem in imbalance of balance of payments resulting from depletion of official reserves in foreign currency, which is occurred during the regime of fixed exchange rates (Frenkel 1999). It should be noted that, the slowdown in rate of inflation and stabilization of the economy through regulation of money supply and use of free floating exchange rate requires from the Central Bank of the country to implement certain interventions to prevent excessive currency fluctuations. Experience of developing countries has shown that, the most progressive reforms in the former socialist countries, managed floating is possible only if the Central Bank manages to build enough foreign exchange reserves or through the achievement of current account surplus, or through loans from international organizations. Like any other regime, regime of independently floating rate should be reviewed taking into account the national circumstances of economy of the country, in which it is intended to use. Otherwise the national currency can lead to negative consequences. Full freedom of movement of capital, in case of economic reformation, may result the increase of speculation in the national currency, which are particularly devastating in the initial phase of the reformation process. The large capital flows can cause big fluctuations in the level of official foreign exchange reserves and thereby influence the money supply. These fluctuations, in turn, make the interest rate on deposits very unstable and further create an atmosphere of distrust. 18

20 In these circumstances, when country's economy is experiencing structural changes, the currency restrictions may contribute to the stability and independence of monetary policy. The Central Bank must develop the clear principles of organization of exchange controls, as part of exchange controls, to minimize the destabilization of speculative expectations. 1.7 Advantages and disadvantages of alternative exchange rate regimes The choice of exchange rate regime is determined to a large extent by the economic objectives of the Government: - Regime of fixed exchange rates constrains the government with a negative balance in international payments. Consequently, when moving to a floating exchange rate regime, the countries with deficit in balance of payments have more freedom; - For countries with deficit in balance of payments deflationary policies are recommended, for countries with surplus inflationary policy. In this case, the rejection of fixed-rate and shifting to a floating regime leads to inflationary policies. In case of downturns within the economy, it is necessary to consider and take into account the reasons for its occurrence it could be either in the financial area, or in production. In case of crisis caused by disorder in financial markets, as a result of short-term market fluctuations, the fixed exchange rate regime will allow to stabilize crises for short term, on condition that Central bank has strong international reserves. In case of crisis in the sphere of production, the use of fixed-rate regime without a radical restructuring economic mechanism will lead to the depletion of foreign reserves of the State and worsen external economic imbalances in the form of deficit in balance of payments (Deverux & Engel 1998). 19

21 It can be concluded that the choice of best option exchange rate regime should be implemented by taking into account the national characteristics of the economy: - A system of fixed exchange rates is more effective in stabilizing the money and the money market, while flexible exchange rates has more advantages to stabilizing production and improve the balance of payments; - if the country in the single monetary zone of fixed currency exchange rates, fixed rates are applied in short-term market fluctuations in the domestic financial market. Prolonged use of fixed exchange rate regime can lead to unnecessary expenditures of maintaining fixed rate and macroeconomic imbalances. In addition, when choosing a regime of exchange rates it is important to take into account the rate of inflation and the level of the reserves in foreign assets: - If the country's inflation rate slightly higher than the rate of inflation abroad, depreciation of own currency should be implemented. But if there is significant difference in the level of inflation, and the imbalance in the structure of costs and prices is remarkably high, then in order to get out of current crisis, floating exchange rates will be implemented on both a short and long term; - If the foreign exchange reserves severely depleted, and the external debt has reached a very significant level, it is necessary to have stronger regulation of the exchange rate in order not only to maintain international competitiveness, but also to build a reserve, which is necessary for adjustments of volatility of balance of payments. None of the optimal currency regimes can fully protect the national economy from external shocks (Frenkel 1999). The exchange rate regime is the only supplementary instrument of national monetary system. Only an effective mechanism of currency 20

22 controls, built on clearly defined principles, minimizes and warns about the consequences of external shocks to financial markets. Policy measures of currency regulation in a certain period of time have a positive impact on economic developments within the country, investing domestic savings for manufacturing inside the country. However, the legislative regulation in general cannot substitute the economic policy which is oriented to stabilize prices. Currency restrictions cannot provide long-term stability of the exchange rate and exchange rate policies. Such a long term stability is possible only on condition that the mechanism of monetary policy is directed to stabilize prices and to set strong foreign trade balance. 21

23 2. LITERATURE REVIEW In the analysis of literature I focused firstly on works about exchange rates in general and then by each factor selectively. The main concern was, considerably, the founders of approaches or models where I could get basic insights of the reviews. The topic of currency exchange rates and factors those drive exchange rates change have been reviewed by many scholars in the last decades and still remains to be one of the hot topics in international economic studies. In the works about exchange rates the analyses were theoretically proven and found empirical evidence as well. Most of the scholars came to similar conclusion, even though they focus not the same factors. In the center of my research is notion of exchange rate, which has long term effect on the economy. And from nominal exchange rates position, inflation is the main factor for rate changes. Defining currency exchange rates by inflation takes grounds Barro- Gordon model of explaining monetary policy (Barro&Gordon, 1983). The first attempts to analyze exchange rates behavior was done by Rudiger Dornbusch(1973), Richard Meese(1979) and Kenneth Rogoff(1983). Since his first major publication in 1973, Rudiger Dornbusch has been one of the most productive and influential economists working on exchange rate economics. Three papers written since 1980 on special exchange rate arrangements, black markets, and stabilization policies under inflation are directed to the experiences of some of the Latin American countries. He also includes papers treating overlapping wage contracts, incomes policies as supplements to devaluation, imperfect substitutability of internationally traded financial assets, and imperfect competition and oligopoly as a means of understanding how prices respond to changes in exchange rates. The essay on purchasing power parity (1987), effectively summarizes its history, problems, and potential. Dornbusch makes clear that it remains an important concept, though the evidence in recent years is more remarkable for deviations from, than observance of, such parity. I his work in 1986 he used modified Mundell-Fleming model to include exchange rate expectations and lagged price adjustment. The shortcoming of that model was that only short run and short-to-medium run portfolio model could be 22

24 analysed. Dornbusch mentioned the failure to include real assets and investment as one of the limitations of the modified Mundell- Fleming model, along with an absence of effects from the current account and the assumption of perfect substitutability between home and foreign bonds. He also emphasized the rewards that may come from bringing tools of industrial organization into exchange rate analysis. Moreover, he suggests taxing international transactions to reduce speculative capital flows and the excessive volatility of exchange rates that they produce. In 1980s Richard Meese and Kenneth Rogoff first explained the shortcomings in monetary models of exchange rates, they were first to say exchange rates essentially follow a random walk, and whatever "fundamental" determinants may be present have eluded empirical research. But before in 1979 Michael Mussa set a standard that seemed both reasonable and achievable: a reduced-form exchange rate model proved itself by explaining 10 % of the quarterly variation in rates between the major floating currencies. In the Journal of International Economics, Meese and Rogoff (1983) focused on out-of-sample forecast failures, and Boughton (1987) showed that monetary models performed just as badly as inside sample. Subsequent literature examined whether the problem was that the basic model should be expanded to incorporate more structural features, simplified and directed toward lower frequency variation, or scrapped altogether. Jerome Stein and Polly Reynolds Allen developed new Natural Real Exchange Rate (NATREX) approach, they stressed that the natural rate was a moving equilibrium that depended on internal changes in stocks of external assets and liabilities (Stein et al. 1995). The valuable property of the NATREX was that in a short term analysis it was possible to integrate stocks and flows. The combination of exchange rate analysis and the factors that determine nominal exchange rates was clearly performed by Philip Lane (Lane 1999), he did theoretical and empirical research on long-run exchange rates and built own model. He analysed long run nominal and real exchange rates, and added to his model variables like trade openness, country size, central bank independence (CBI) and government debt. One of the special points of his work was that he analyzed 107 countries for the period of Before him all the works had included only special concentrated regions of developed countries within less time period. 23

25 As he constructed model, nominal and real exchange rates had different determinants for empirical data, and he carried out LS regression to get the statistical results. As a benchmark country he used the USA, indeed US dollar assumed to be best comparison for currency exchange rates after Bretton-Woods system (Lane 1999). For real exchange rates economic growth and terms of trade were chosen as potentially important factors. To obtain estimates for nominal exchange rates he used openness, size, debt, CBI index and inflation, but as long as some of the variables are as important to analyze real values as nominal ones, Lane constructed equations with selected determinants. As of empirical analysis, Lane created several classifications: countries with inflation higher than 30% and vice versa; countries with non-autonomous exchange rates, countries with high appreciation/depreciation rates, etc. His econometric results show that the factors driving long-run inflation are as important as for exchange rates. Explanation power of the model declined while the excluding countries with high inflation and high depreciation rates (Lane 1999). In full sample data, openness, output growth and the terms of trade resulted to be significant, but country size was insignificant. In overall, results show that the debt effect is most important for high depreciation/inflation countries. Openness, size, and the stock of nominal government debt - variables that affect the tendency to inflate - are significant in explaining the rate of nominal depreciation. However, the support on central bank independence is weaker. The output growth rate - which affects the long run in the real exchange rate - also is important in explaining the nominal exchange rate. However, the results for the terms of trade, another factor that ought to affect the nominal exchange rate via its influence on the real exchange rate, are mixed. For the OECD, and consistent with the PPP evidence, the factors driving inflation appear to dominate the determination of the nominal exchange rate (Lane 1999). In extending of his work, Philip Lane stated that considerable progress needed to be made in achieving a better understanding of the determination of the real exchange rate and a large fraction of the long-run variation in real exchange rates across countries remained to be explained. In later parts of my thesis, I would add updated data for Lane s model of exchange rate formulation and identify changes over time interval. 24

26 One of the prominent researches in the field of exchange rate fundamentals is done by Peter Clark & Ronald Macdonald in They compare two approaches for exchange rate determinants: Fundamental Equilibrium Exchange Rate (FEER) and Behavioral Equilibrium Exchange Rate (BEER) (Clark & MacDonald 1998). In FEER approach the equilibrium exchange rate is defined as the real effective exchange rate that is consistent with macroeconomic balance, which is generally interpreted as when the economy is operating at full employment and low inflation (internal balance) and a current account that is sustainable, that reflects underlying and desired net capital flows (external balance). This exchange rate concept is denoted as fundamental in that it abstracts from short-term factors and emphasizes instead determinants that are important over the medium term. An assessment of a country's exchange rate was made by comparing its current level with the calculated FEER (Clark & MacDonald 1998). BEER approach is the use of an estimated reduced-form equation that explains the behavior of the real effective exchange rate over the sample period. This paper illustrates two approaches with the estimation of equations for the real effective exchange rates for the German mark, the Japanese yen, and the U.S. dollar using cointegration methods. The sample period is and the USA, Germany and Japan had been chosen. As for BEER variables Real effective exchange rate, Terms of trade, price ratio of non-traded goods to traded goods, Net foreign assets, stock of government debt and real interest rate constructed the equation. As we can see Clark & MacDonald (1998) and Philip Lane (1999) introduced similar models except for exact number and name of determinants. But unlike Lane, Clark & MacDonald performed statistical country by country separately so that there would be no correlation among country specific data. They have done comparison of BEERs and FEERs to see the extents of the two models. It showed that the dollar would have been considerably stronger, using the BEER analysis, if the U.S net foreign asset position had not deteriorated since 1980 (Clark & MacDonald 1998). But the comparison of the estimated BEER with the FEER for the German Mark was not very revealing. By contrast, the BEER estimates for the yen appear to be plausible, particularly over the second half of the sample. As 25

27 the BEER analysis showed a strong upward trend in the estimated equilibrium value of the yen, the estimated FEER overvalued the average real values (Clark & MacDonald 1998). It is notably that FEER comparisons are made on past observations; however there had been other researches of FEER for future equilibrium points in exchange rates (MacDonald 1997). According to authors statements, with some appropriate counterfactual assumptions, model could also be used to calculate ex ante equilibrium rates in addition to the ex post rates. They conclude that, behavioral approach to identifying misalignments involves that the level of exchange rate is sustainable as long as the values of the economic fundamentals are also sustainable. In other words, variables of BEER are abstract and do not have any significance as standalone. However, the actual exchange rate returned to the statistically estimated BEER values (Clark & MacDonald 1998). The mirage of fixed exchange rates by Maurice Obstfeld and Kenneth Rogoff also has great influence on exchange rate studies. Obstrfeld and Rogoff decided to show shortcoming of fixed exchange rate regime as many economies collapsed in 90s due to pegging national currencies, e.g. the UK and Mexico are among currency crisis faced countries (Obstfeld & Rogoff 1995). They reckon the statement that, efforts to reform monetary institutions should focus directly on restraining domestic inflation. The exchange rate should be used as an indicator but virtually never as the central target for monetary policy (Obstfeld & Rogoff 1995). They note also, a government that fixes its currency exchange rate loses control of the domestic money supply. The main focus of this article is to give theoretical understanding of exchange rate changes and role of government via direct or indirect intervention. Foreseeable future of fixed rates and adaptation of low inflation from pegged country are mentioned as advantages of fixed exchange rate regime. However they bring Mexico s financial crisis as an example of not following US Dollar inflation as written in the theory (for more information about Mexico crisis refer to the source). 26

28 The number of pegging countries and their successful/unsuccessful outcomes in monetary policy led to make following conclusion: only a very small number of fixed exchange rates had survived the past several years intact. Fixed rates normally are still technically feasible, for most countries can easily collect the resources needed to buy back their monetary reserves (Obstfeld & Rogoff 1995). However, present capital markets blow up any weaknesses in a country's commitment to a fixed rate and country has to face attack of speculation leading to high level of control. In the field of inflation there have been plenty of researches, and they have been connected with many other macroeconomic variable. Theoretical and empirical analyses went deep into causes of inflation changes. For my topic inflation is one of the variables that determine exchange rate series, I analyse inflation s share in alterations if currency rates as along with other determinants. I progress further within inflation and touch the matter of Central Bank Independence (CBI). CBI index has a direct connection to inflation, but it has significant effect to the changes of exchange rates too. The theoretical and statistical proof of this is done by Cukierman as pioneer in this topic. The real development of this case is carried out by Cukierman, Webb and Neyapti in 1992 and had put initial stones for unlimited investigations within inflation. Their statement is the degree of independence of the central bank from other parts of government affects the rates of expansion of money and credit and, through them, important macroeconomic variables, such as inflation and the size of the budget deficit. Governments often pass laws and follow customs that grant their central banks authority and autonomy to pursue price stability, even when it conflicts with other government objectives. The central bank's pursuit of price stability can help reduce inflation costs. Sometimes the government has strong tendencies to focus on issues other than price stability, in that case central bank independence and an explicit mandate to pursue price stability are generally regarded as important institutional devices for ensuring price stability. The main value of this article is unified and broadly based measures of Central Bank Independence. The legal and economical independence of central bank are combined 27

29 to single index. Cukierman and others formed special questionnaire with certain weights to each answer. 72 country central banks were involved in the analysis. Calculated index range is between 0 and1. The higher the index, the more independent is the central bank. The lower is the CBI, the higher is the possibility if uncontrollable inflation. The parts of the questionnaire concerned the years of election cycle, governor turnover rates, limitations on lending, resolution of conflict and the others. Moreover, specialists on monetary policy in 23 central banks had been given other kind of questionnaire to identify divergence between actual and legal independence. As the result of the answers of these questionnaires, authors state that countries with high CBI index had less annual inflation rates, and vice versa, countries with lower CBI index had higher price changes (Cukierman, Webb & Neyapti 1992). The top five high CBI index countries were Germany, Switzerland, Austria, Denmark and the USA within the range of 0,5-0,7; these countries follow the general rule: the maximum average annual inflation observed was 5%. But on the basis of questionnaire answers of specialists there were some countries that present moderate CBI index although they show very stable price levels. Belgium and Barbados are good examples of this kind of sample. Cukierman et al. mention this as result of subjective evaluation and questionnaire-based index could contain more noise than legal index. The authors comment that "Austria, The Bahamas, Belgium, Luxembourg, Netherlands, and Panama have lower inflation in the 1980s than their central bank independence would indicate, because their monetary policy is dominated by a policy rule fixing their exchange rate to a relatively stable currency. In this statement the authors are actually suggesting that the adoption of a fixed policy rule for the exchange rate will modify the relation between central bank independence and inflation performance. In fact, more than one-third of the developing countries in their sample have fixed exchange rate rules. Explicit recognition of differences in exchange rate-fixing arrangements increases the empirical support for their hypothesis that connects central bank independence and inflation. The CBI analysis of Cukierman was implemented for limited number of countries, but this was fundament for further hundreds of research papers on Central Bank Independence and Inflation. On the basis of weighting rules of answers of 28

30 questionnaire similar indices have been developed and applied to wider range of countries and longer periods. Cukierman, Webb, and Neyapti had constructed a combined measure of central bank independence derived from a regression of their index of legal central bank independence and the rate of turnover of central bank governors on the rate of inflation. The further developments of similar research are not rare in academic journals. And one of the significant and recent works is Central Bank autonomy: Lessons from Global Trends by Marco Arnone, Bernard Laurens, Jean-François Segalotto, and Martin Sommer in Arnone et al. continued CBI analysis with new approach, their work covered worldwide scope. Legal CBI is calculated for 163 central banks, representing 181 countries as end of The methodology for assessing CBI is based on Cukierman (Cukierman et al. 1992) and Grilli (Grilli et al. 1991). Grilli et al. distinguished political and economic dimensions of autonomy, while Cukierman provided legal autonomy with regard to Central Banks chief executive officer questionnaire. Arnone et al. combined the two methods into one and made so called full index CBI that includes much more subsets than 10 as in Cukierman index. The next nuance is comparison across counties and evolution over time. They have country groups like advanced, emerging and developing counties; late 1980 and 2003 CBI indices to compare. For broader information refer to full articles. The empirical part includes correlation of CBI and inflation for the sample. Specifically, the model specification includes trade openness, inflation in advanced economies, the fiscal balance scaled by the depth of the domestic financial sector, the exchange rate regime, and two alternative measures of CBI. On average, a move from no autonomy to full autonomy increases the likelihood of maintaining low inflation by about 50 percent. In the sample, the average autonomy of central banks in emerging markets increased from 0.3 to about 0.7 over the past two decades, which implies an average increase in the likelihood of low inflation by about 20 percent (Arnone et al. 2007). Eventually, they conclude that the movement toward greater Central Bank Autonomy had paid off in terms of sustained low average inflation levels in many emerging market and developing countries. 29

31 I want to go through one more article which I found important in the literature. It is openness category, and it has great influent to the exchange rate trend. The chosen article is written by David Romer published in 1993 with the name Openness and inflation: Theory and Evidence. The article conveys correlation between inflation and openness, but it is as important for exchange rates as for inflation. Unanticipated monetary expansion leads to real exchange rate depreciation, and because the harms of real depreciation are greater in more open economies, the benefits of unanticipated expansion are decreasing in the degree of openness (Romer 1993). Sample of Romer conveys post-1973 period, and involves up to 114 countries depending on the scope of analysis. Empirical statistics includes openness, real income per capita, revolutions and CBI index. He also divided countries into groups to better analyze statistical outcomes. Author tested the sample for high correlation between inflation and openness. Although the results are generally robust across subsamples, there is no evidence that the prediction of the theory holds for the most highly developed countries. More important, average inflation rates in these countries are low. Outside group of highly developed countries, in contrast, average inflation rates are high and are strongly related to openness (Romer 1993). Further Romer gives explanations to the unexpected results of regression. The first explanation is that openness is endogenous. The ratio of openness depends not just on a country's size but also on the country's policy choices. The second alternative interpretation is that the negative association between openness and inflation reflects considerations involving the government budget and seignorage. The amount of revenue generated by a trade tariff is increasing in the openness of the economy. Thus, the governments of smaller countries may obtain larger fractions of their revenues from tariffs, and may therefore rely less on other sources of revenue, including seignorage. The result might be lower rates of inflation. According to Romer s conclusions, average rates of inflation are lower in smaller, more open countries (Romer 1993). The only exception is a group of highly developed countries, they have low average inflation rates but there is no relation to openness ratio. 30

32 3. EMPIRICAL ANALYSIS 3.1 Data Description and Methodology Throughout the paper I focus on the post-bretton Woods period In the Bretton Woods era countries agreed to coordinate their monetary policy in order to fix their currencies with respect to gold. This implies that chosen time is a natural period to focus on in the analysis of the exchange rate and other variables. The sample includes 82 countries of the world. I started with 188 countries, but unavailability of data for whole period or at all reduced the full samples size. Taking the averages and filling empty data with averages cannot give real picture of exchange rate changes and weight of each variable. In my empirical analysis I use following variables: -Nominal exchange rate: nominal exchange rate against USD -Real exchange rate: real exchange rate against USD. -Inflation: nominal inflation as Consumer Price index -Openness: sum of Export and Import divided by GDP. The ready data is taken from Penn World Tables -Growth: per capita output (GDP) growth rate -Terms of Trade: growth rate of Terms of Trade (Export/Import) -Size: total GDP, to see how changes in GDP affects my dependent variable I take log changes of GDP. -Debt: government debt over GDP -CBI: Central Bank Independence index, based on Cukierman (1992) and Crowe & Meade (2008) 31

33 Data on the nominal exchange rate and inflation are taken from the IMF's InternationalFinancial Statistics. GDP, GDP growth and per capita GDP growth rates are taken from World Development Indicators of the World Bank. Debt variable is also from World Bank s WDI data. Terms of trade are calculated from the Exports and Imports values of IMF International Financial Statistics. Openness variable is from Summers-Heston Penn World Tables version 6.2 which is the latest at the date. CBI index is provided by Christopher Crowe and Ellen Meade, who extended Cukierman s CBI index for other countries and presented revised version of CBI for end of Debt variable is ratio of General government debt to GDP, in academic papers Public debt is being used in the same meaning as general government debt. Lane (1999) used debt variable as constant from 1975, in other words his debt variable is debt/gdp from But I decided to update this data, and use averages for a chosen time period. I believe the changes in government debt have significant effects to changes in inflation and/or consequently to exchange rate. Empirical results will show the how significant is my assumption. For 20 countries I could not get full data for Debt from World bank sources, but I could find government data for some of them 20 from OECD database. But government debt was only for central government debt, it was not sufficient for my DEBT variable. Finally I was able to find necessary data for European countries from EUROSTAT. But anyway I still needed some data for Bolivia, Ghana, Macedonia, Armenia and a couple of countries. Then I referred to national statistics, Central Bank of these countries provided with sufficient data so that I did not have to take data from unofficial sources. CBI index is provided by Crowe & Meade in connection to data request by . It includes Cukierman et al CBI index covering 1980s and updated/modified index of Crowe&Meade for the years till Nominal exchange rates, openness, Size as GDP are presented as log values. Inflation, GDP Growth and Debt variables are given in percentages. Terms of Trade and Real 32

34 exchange rate are calculated as annual change. For chosen period all the variable are taken as averages. The specification of countries that lack independent exchange rate policies, which helps to group countries in Statistical analysis, is extracted from IMF s Exchange Rage Arrangements and Practices of the year 2004, because my full data includes countries up to And it will give recent pictures of country exchange rate frameworks. 3.2 Empirical Analysis For statistical model I use nominal exchange rate as an equation of inflation differential and real exchange rate. For the empirical part Regression analysis is chosen. And I will use LS method, I also intended to apply other Panel analysis statistical methods, but unavailability of data for each year and the big volume of the work did not allow me to take panel analysis. This will maintain the power of the model and preciseness of the determinants. Theoretical fundaments are based on Purchasing Power Parity (PPP) for national currencies and Barro-Gordon policy for long run inflation rates. Conversion of nominal exchange rates into real rate is done by the following equation: R i =E i *(P us /P i ) Where R i is Real exchange rate of country i against USD, E i is nominal exchange rate for the country i against USD from IMF database, P us is inflation in the USA, P i is inflation in country i. The log changes model of above-mentioned formula could be rewritten as: (Lane 1999) where is the rate of nominal exchange rate, is inflation rate in country i, is the inflation rate of the USA and is the rate of real exchange rate. According to equation, the rate of nominal exchange is faster, the higher is country i's inflation rate relative to that of the USA. And there is positive relation with real exchange rate as well. 33

35 From this equation it is clearly visible that if I can define determinants of country specific equilibrium long-run inflation rate and factors that affect the long-run change of real exchange rate, I will be able to state exactly what determines the movement in nominal exchange rate. Now what remains is to analyze determinants of the rates of inflation and real exchange rate. Cukierman et al did significant research on relation of CBI index with inflation. Their conclusion was that the lower rate if CBI, the higher rate of inflation, which means clear negative relation (Cukierman et al 1992). Romer (1993) researched relation of openness with inflation and had found negative connection between them. In 1996 Campillo and Miron made research on determinants of inflation and they assessed inflation rate by using variables Central Bank Independence index, political instability, Imports/GDP, Income, exchange rate regime, debt/gdp and quality of the data. Level of income is estimated to have negative sign with inflation (Campillo & Miron 1996). Authors state that openness and the level of income were significant, but with negative impact. Government debt and inflation proved to have positive relation. And the final statement was that, holding constant all the factors discussed, the level of GDP per capita is consistently positively related to inflation. In 1998 Clark & MacDonald performed analysis of economic fundamentals of exchange rates, they have conducted empirical test of terms of trade, relative price of nontrade to traded goods, net foreign assets and real interest rates on real effective exchange rate. They released the same sign of relation as other above-mentioned authors. As for latest research papers, in 2008 Crowe & Meade have done analysis of Central Bank Autonomy, and they have found less significant results between CBI and inflation than Cukierman et al did. To sum up, many scholars found similar relation between selected variables and inflation. They had different level of significance in varying subgroups. In the following section I try to analyze specific six econometric variables on exchange rate. 34

36 As long as my aim is to find what determines nominal exchange rate and how significant these variables are, I focus on significance of the variables and power of the model. My sample is 82 countries worldwide, the number of countries was defined through statistical data collection. When data gap between years was big I dropped that country. Many variables were available until 2005, but for the sake of some variable like Cenral Bank Independence (CBI) index and government debt I have to cut observed time period to In addition to considering full sample, I examine a number of subsamples. To determine whether statistical results derive mainly from the influence of a few extreme observations, I consider samples that omit countries with average inflation rate more than 30%, the sample that includes countries which have data for whole period and last sample of countries which have available data only for period Here I try to group countries and/or variable into different subgroups to get remove noise and insignificant factors: 1. All countries, full sample; 2. Countries with average inflation rate less than 30 % 3. Countries with values for Countries with available values for only Former Socialistic Countries. For all of above-mentioned subsamples I commit the following regression equation analysis: A. Nominal exchange rate - Inflation B. Nominal exchange rate - Openness, Size, Growth, Terms of trade C. Nominal exchange rate - Openness, Size, Growth, Terms of trade, Debt, CBI index D. Real exchange rate - Growth, Terms of trade. For full information about variables, calculation and sources refer to data description section. 35

37 Table 1. Descriptive statistics for full sample Notes: All the variables are average annual data. CBI is Central Bank Independence index calculated by Cukierman(1992) and Crowe&Meade(2008). Debt is Government debt over GDP, given in %. Growth is GDP per capita average annual growth for of 82 countries. Inflation is Consumer Price index, average of yearly changes is taken. Nomxrate is average annual changes of nominal exchange rates against USD over Openness is ratio of export plus import to GDP. Realxrate is average annual change in real exchange rate agains the USA price level for the period Size is total GDP, given in average of annual percentage changes. TOT is growth rate of terms of trade (Export/Import). Full description of variables are given in data description section. Table 1 provides summary of descriptive statistics for all variables in the full sample. CBI index being theoretically between 0 and 1, here it is just on the middle, Public Debt over GDP ratio is 56%, it is average of 82 countries for 30 years period ( both years including), and it is quite big compared to for recent years. The highest indebted country Zambia has 190 % debt over total output. It is not surprising that the minimum indebted country is Luxembourg with only 4.5%. Per capita GDP growth has range of -4% up to +13% average annual rates. The highest average rise has been noted in Albania, this is quite reasonable, because for small economy high growth rates do not really mean that they are fully industrialized, these changes are not stable. For Albania I have data starting from 1992, the average value is taken only for 11 years then. The followers of Albania in this race are countries of South-East Asia, known as Tigers for their recognized growth rates. Number one important factor in this rank, Inflation variable, seems logically acceptable, average 43.7% within the range of 0.6% - 469% shows that the weight of economies with stable price indices is bigger. This increases power of model; it is not analyzing extraordinary changes due to crises or wars. If I comment on exchange rates, average annual change in nominal rates is 40%. The leaders are Bolivia, Peru and Brazil. I accept this as correct result of statistics. Bolivia in years had very high changes in exchange rates, even though it was not shocking high depreciation, in annual change terms it could be very sensitive. Albania, Croatia and Brazil have shown highest annual changes in real exchange rate, for Croatia and Brazil this related to high inflation rates too. 36

38 In growth rate of GDP (Size), year-on-year percentage changes of constant price GDP are taken, the base year for constant price is country-specific (IMF World Economic Outlook). Data being constant values and average for full period, the values are not so high. Mean GDP growth rate is 3%. The growth rate of Terms of Trade is also not in line with expectations. It is due to changes in Export and/or import. For instance, Uganda s Exports increased dramatically in 1991 and 1994, while its imports decreased slightly. These movements set Uganda to be of highest growth rate of Terms of Trade. As it is clear from the table 2, 14 countries out of 82 in my sample have experienced nominal appreciation against the US Dollar over Austria has shown average annual 4.2 % appreciation over 30 years. The rest is other members of European Monetary System and they have appraisingly stable inflation rates. The only exceptions are Lithuania and Latvia that have 18.8% and 15.2% average annual inflation rates. The reasons for appreciation of the two countries can be their future involvement in EURO zone and/or effects of Euro as they trade mainly with the countries of Euro area. Table 2. Appreciating countries Note: Countries that experienced nominal appreciation against USD over IMF International Financial Statistics and author s calculations. Table 3 exhibits the countries that are in Euro area and using Euro as national currency. The year of entry to Euro system is given to be aware of from which date inflation and other variables effects are limited. But as these countries use same currency and European Central Bank watches over Euro changes, this has spillover effect to other factors in my model, in other words, after euro introduction their inflation, debt and growth variables starts converging and have similar growth rates. Moreover, in this table the list of EU countries that pegged national currencies to EU is very useful. It helps to understand trends in exchange rates. As theory of exchange rates state, when country pegs to other currency, there is big change that the pegging adopts inflation and interest rates of host country (Edwards & Losada 1994). 37