Real Exchange Rate and Economic Growth
Exchange rate represents the currency of on country in terms of other country. Therefore, an exchange rate chiefly has two components, which are, the domestic currency and the currency of foreign country. Relation between two currencies can be described in either direct way or indirect way. According to the direct quotation, price of one unit foreign currency is described in terms of the currency of domestic country (Gabaix & Maggiori, 2015). On the other side, according to indirect quotation, price of one unit domestic currency is measured with the help of foreign currency. Movements of exchange rate affect trading relationship between two or more than two countries.
Real exchange rate and economic growth has close relation. According to (Guzman, Ocampo & Stiglitz, 2018), undervaluation of the currency can stimulate economic growth of a country. This condition is applicable especially for developing countries. According to various researchers, poorly managed exchange rates have adversely affected economic growth of a country. Consequently, it has become essential to avoid currency overvaluation (Ajibola, Enilolobo & Theodore, 2017). Due to different outcomes of the economic growth across the world, overvaluation of currency occurs. Statistical evidence of cross-country has supported this view. Some articles have represented the relationship of outward orientation with economic growth. This relation deeply depends on various indices, which considers degree of valuation. However, some other researchers oppose regressions related to cross-national policy. According to them large amount of overvaluations have affected growth of a country adversely. This is because overvalued exchange rate has relation with shortage of foreign currency along with corruption and rent seeking (Alagidede & Ibrahim, 2017). Moreover, overvalued exchange rate has relation with deficits with large current account, crisis in balance of payments along with other macroeconomic cycles that can hamper economic growth.
Thus, literatures have stated various explanations related describe that how real exchange rate influences economic growth. This explanation chiefly focuses on the deviations of actual real exchange rate from the ideal one. This ideal exchange rate is termed as misalignment that considers two forms, which are, undervaluation and overvaluation. These two forms have different impacts on economic growth. According to Comunale, (2017), overvaluation and undervaluation of exchange rate considers the impact of exchange rate policies and distortionary monetary policies that depend on the resource allocations between import competing sectors and exporting sectors.
Exchange rate regimes refer the process through which the value of domestic currencies is determined in terms of foreign currencies. For policy makers, it is crucial to prevent financial crisis after the occurrence of global financial crisis. In modern years, currency crisis is the most common type of financial crisis. Many economists along with scholars, central banks and international financial institutions have discussed about currency mechanisms crises in both empirical and theoretical way (Lothian, 2016). Few researchers have analysed about various types of shocks for which currency crisis can be occurred. In this context, a relation between policies related to exchange rate and probability related to shock can be described. Most of the literatures have discussed about the effectiveness of monetary policy responses on currency crises. Some researchers have observed that domestic currency appreciation can increase the interest rate policy of many developing countries (Kurokawa, Pang & Tang, 2016). However, it is observed that currency crises cannot be managed through fluctuating interest rate. This is because various exchange rate policies have different impacts on the currency crisis. For instance, floating exchange regime of a country can freely respond to any shock. Thus, a country can experience currency fluctuation due to nominal exchange rate.
Exchange Rate Regimes
It is essential to distinguish between currency crashes and currency crises. Currency crash occurs when nominal exchange rate depreciates by a certain percentage of thresholds. This occurs due to high inflation or due to speculative attack (Montecino, 2018). On the contrary, currency crisis occurs in the form of balance of payment crisis due to foreign reserve loss or currency depreciation by large extend. Some researchers have stated that overvaluation of real exchange rate along with international reserves act are important to determine currency crashes due to fixed exchange regimes (Bleaney, Saxena & Yin, 2018). On the contrary, they have found that credit growth is essential for floating regimes.
Foreign exchange rate risk describes about the financial risk due to which value of an investment may change when value of two currencies of distinct countries change. This foreign exchange rate risk is also known as currency risk or exchange rate. Investors experience this form of risk at the time when they require closing out a short or long position in a foreign currency (Della Corte, Ramadorai & Sarno, 2016). They do this under loss that occurs due to exchange rate fluctuations. There are some exposures related with foreign exchange rate risk, which are translation exposure, economic exposure and contingent exposure. In this context, some researchers intend to analyse the process of managerial risk-taking incentives. They consider foreign exchange rate risk as the ideal risk that can help to investigate various incentives related to managerial risk-taking depending on specific firm risks. This can happen due to various reasons, such as globalisation. Increased exchange rate in globalised market has become an important issue for prices among managers in US economy. Some researchers have stated that changing of exchange rate has become an important determinant for many US firms to perform (Cenedese, Sarno & Tsiakas, 2014). In this context, some other researchers have stated that one third of firms adjust their discount rate and cash flows for accounting exchange rate risk in order evaluating project. According to those economists, exchange rate can adjust any single risk except the market risk. Thus, changing exchange rate has significant impact on activities of firms, which perform internationally.
In some recent studies, researchers highlight that changing of exchange rate has imposed some risk on firms and consequently has affected corporate operations directly along with capital cost and value of firm. Some researchers address exposure of exchange rate as the changing value of firm due to some unexpected changes that take place in exchange rates. Thus, Habib, Mileva & Stracca (2017) have provided a model of single factor that measures exposure related to the stock returns sensitivity for changing the exchange rates. In this aspect, it is essential to observe that risk related to exchange rate can affect multinational firms, which perform import and export businesses. Moreover, this exchange rate risk can influence these companies, which do not operate any international business activities (Kuersteiner, Phillips & Villamizar-Villegas, 2018). These firms are called domestic one. These domestic firms are affected in an indirect way due to customers, who are direct importers and exports. These pure domestic companies provide huge competition for these multinational companies, which can be fluctuated due to exchange rate.
Foreign Exchange Rate
Researchers focus on material impact depending on both debt cost and equity cost. According to some of them, increasing exposure of exchange rate could increase loan spread significantly (Bodenstein, Erceg & Guerrieri, 2017). Thus, exchange rate exposure has the chance to influence firm value. Therefore, it is essential to investigate some chief determinants related to exposure level. It is observed that exposure of exchange rate can reduce firm value and increase the capital cost. Some studies have focused on the characteristics of firm considering size of the firm, industry structure, tax convexity and international operations. Some other articles consider about decisions of firms related with operational activities like utilisation of foreign debt and hedging policy. Both characteristics and decisions of firms have close relation with exchange rate exposure. Some key determinants like financial policies and international operations related with risk management are the outcomes of decision-making taken by managers (Forbes, Hjortsoe & Nenova, 2018). Moreover, according to survey of some researchers, top managers have discretion on risk management related with exchange rate. Through conducting surveys, researchers have observed that managers possess powers to set policies related with exposure management of exchange rate. Some of them also have observed that managers have serious views on the market of foreign exchange reflecting personal preferences of them (Ahmed, Coulibaly & Zlate, 2017). Moreover, foreign exchange market reflects attitudes of an individual toward risk and specifies options and skills. Thus, it can be said that exchange rate risk management could reduce capital cost and increase firm value. However, attitude of managers towards risk management is associated with their interest of wealth maximisation.
Researchers have identified that fluctuations of exchange rate are difficult to observe and in this aspect, no standard models of economics can help them. However, researchers have suggested that some factors like decisions of predictor, forecasting model, forecast horizon and methods related to forecast evaluation could influence the predictability of exchange rate (Byrne, Korobilis & Ribeiro, 2018). Therefore, the power of prediction becomes specific for some countries for some specified periods indicating instability in the forecast performance models. Some researchers have also pointed out this instability in model. According to them, it is difficult to overcome the benchmark of simple random walk through the models of fundamental exchange rate. They have also seen that professional forecasters cannot provide adequate forecasts of exchange rate. Thus, various researchers have discussed about the uncertainty role related to change in expected exchange rate by professionals along with outcomes of forecast errors. According to perspective of theories, changing of unexpected exchange rate is an outcome of unexpected changes or news in fundamentals. In recent times, researchers have suggested that forecasting of adequate exchange rate need a fundamental understanding (Ismailov & Rossi, 2018). Thus, it can be said that uncertainty has a potential influence on forecast errors and expectations. Other researchers also have argued that some information related to fundamentals has helped to persistent non-fundamental exchange rates along and confusion of sources related to fluctuation of exchange rate.
In this context, it can be said that uncertainty can influence expected profits in the market of foreign exchange due to shift of exchange rate regime. Changing conditional variance related to exogenous processes can influence the risk premium potentially in the market of foreign exchange (Beckmann & Czudaj, 2017). Moreover, this changes cause spot rates volatility. As stated before, measurement of expected exchange rate is difficult. Moreover, forecasts related to subjective survey can be observed as biased. Therefore, various studies have considered exchange rate expectations related to survey data without any approximation regarding future exchange rates.
Some literatures have stated that real exchange rate at a competitive level can help economists to overcome their productive and technological asymmetries. Researchers have stated about the stable real exchange rates, which are depreciated. These exchange rates cab help to exports diversifications (Nakamura, Sergeyev & Steinsson, 2017). However, real exchange rate, which has obtained overvaluation, can discourage companies to in luxurious goods to trade. This further decrease the tendency of negativity and learning that can affect income elasticity. According to researchers, success can be helpful regarding process and convergence after the second war II. Large exporters have considered as large importers. Thus, researchers have tried to understand that low exchange rate at an aggregate level can help exporters. This is because lower exchange rate can offset the marginal costs (Auer & Schoenle, 2016). Therefore, firms of import-orient can influence shares of export market. This is due to high mark-ups that can move in response for changing the marginal cost. This provides the impacts of exchange rate shocks.
Hence, the above discussion has showed various aspects of exchange rate. In modern economy, this exchange rate helps a country to trade with others. This can promote exports and imports of business. Thus, researchers have analysed various aspects of exchange rate. Real exchange can influence the economic growth of an economy (Berka, Devereux & Engel, 2018). This, paper has discussed about structural change along with real exchange rate, uncertain predictability of exchange rate and foreign exchange rate.
References:
Ahmed, S., Coulibaly, B., & Zlate, A. (2017). International financial spillovers to emerging market economies: How important are economic fundamentals?. Journal of International Money and Finance, 76, 133-152.
Auer, R. A., & Schoenle, R. S. (2016). Market structure and exchange rate pass-through. Journal of International Economics, 98, 60-77.
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Berka, M., Devereux, M. B., & Engel, C. (2018). Real Exchange Rates and Sectoral Productivity in the Eurozone. American Economic Review, 108(6), 1543-81.
Bleaney, M., Saxena, S., & Yin, L. (2018). Exchange rate regimes, devaluations and growth collapses. Journal of Macroeconomics, 57, 15-25.
Bodenstein, M., Erceg, C. J., & Guerrieri, L. (2017). The effects of foreign shocks when interest rates are at zero. Canadian Journal of Economics/Revue canadienne d’économique, 50(3), 660-684.
Byrne, J. P., Korobilis, D., & Ribeiro, P. J. (2018). On the sources of uncertainty in exchange rate predictability. International Economic Review, 59(1), 329-357.
Cenedese, G., Sarno, L., & Tsiakas, I. (2014). Foreign exchange risk and the predictability of carry trade returns. Journal of Banking & Finance, 42, 302-313.
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Della Corte, P., Ramadorai, T., & Sarno, L. (2016). Volatility risk premia and exchange rate predictability. Journal of Financial Economics, 120(1), 21-40.
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Gabaix, X., & Maggiori, M. (2015). International liquidity and exchange rate dynamics. The Quarterly Journal of Economics, 130(3), 1369-1420.
Guzman, M., Ocampo, J. A., & Stiglitz, J. E. (2018). Real exchange rate policies for economic development. World Development, 110, 51-62.
Habib, M. M., Mileva, E., & Stracca, L. (2017). The real exchange rate and economic growth: Revisiting the case using external instruments. Journal of International Money and Finance, 73, 386-398.
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Kuersteiner, G. M., Phillips, D. C., & Villamizar-Villegas, M. (2018). Effective sterilized foreign exchange intervention? Evidence from a rule-based policy. Journal of International Economics, 113, 118-138.
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Montecino, J. A. (2018). Capital controls and the real exchange rate: Do controls promote disequilibria?. Journal of International Economics.
Nakamura, E., Sergeyev, D., & Steinsson, J. (2017). Growth-rate and uncertainty shocks in consumption: Cross-country evidence. American Economic Journal: Macroeconomics, 9(1), 1-39.
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