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Exchange Rate Behavior of Canada, Japan, the United Kingdom and the United States

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Abstract

We revisit a significant research topic on exchange rate behavior by restating the test procedures with an appropriate econometric methodology to re-examine three aspects. (i) Does the inflation (price) factor affect nominal exchange rate? (ii) Do relative interest rates affect a country’s exchange rate? (iii) Do the price and interest rate effects hold if controls for non-parity factors are embedded in tests? The quarterly data series for this study are taken over 55 years. The traditional parity condition model with price and interest rate as criterion variables is extended to take into account recently-verified non-parity factors, namely trade, productivity and foreign reserves. The results affirm that both parity factors and also the non-parity factors significantly affect the exchange rates of Canada, Japan, the United Kingdom and the United States. In our view, these findings relating to four free-floating currencies help extend our knowledge on how currency behavior is consistent with parity and non-parity theorems using a relevant methodological approach in this study.

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Notes

  1. See Camarero & Tamarit (1996).

  2. The model has included a variable for inflation as the ln on CPI. Hence, using nominal relative interest rate in the test for IFE would mean that the inflation factor is again included in the second variable. To rectify this, we subtracted the expected inflation from the domestic and the foreign current nominal interest rates so that we test the IFE on the real interest rates.

  3. An anonymous reviewer commented that there could be structural breaks in the time series. The results reported are not likely to suffer from systematic effect of such possible breaks. Several breaks may exist, the combined effect of all of them is likely to be minimal since we used pooled mean group method, which allows for heterogeneity, intercept, slope coefficient and error variances, all of which would limit the effect of structural break in our final results.

  4. An anonymous reviewer commented that the paper has not considered a tax effect from interest rate, which yield incomes subjected to taxes. We are grateful for this comment. Perhaps extending our models in a newer direction may help to extend this current research further into tax effect study as a separate research.

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Acknowledgment

We are grateful to Law Siong Hook for clarifying to us issues of methodology for this study: Karam Shaar provided very useful research assistance. An earlier version of the paper was presented and received useful comments from discussant/participants at the World Banking and Finance Symposium in Singapore, 11–12 December, 2014. The revised paper incorporates amendments and further test results in response to comments from the Editor-in-Chief and two anonymous reviewers of the Journal. The authors take sole responsibility for errors. We acknowledge with thanks the Editor-in-Chief, George S. Tavlas and two anonymous referees for providing insightful comments and directions for revision of the earlier manuscript submitted to the Journal.

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Authors and Affiliations

  1. Faculty of Economics and Management, University Putra Malaysia UPM, 43400, Serdang, Selangor, Malaysia

    M. Ariff

  2. Sunway University, No.5 Jalan Universiti, 47500, Bandar Sunway, Selangor, Malaysia

    A. Zarei

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  1. M. Ariff
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  2. A. Zarei
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Correspondence to M. Ariff.

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Ariff, M., Zarei, A. Exchange Rate Behavior of Canada, Japan, the United Kingdom and the United States. Open Econ Rev 27, 341–357 (2016). https://doi.org/10.1007/s11079-015-9372-x

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