Analyzing bilateral currency exchange rates in predicting economic output.

Boozer, Benjamin B., Jr. ; Lowe, S. Keith

INTRODUCTION

This paper examines correlations between currency exchange rates and economic output in a country. Economic output is illustrated through Gross Domestic Product (GDP). Currency exchange relationships are explored between the United States and the following countries: Canada, Japan, and Sweden. The focus of the analysis is to what extent currency exchange rates and economic output, as measured by Gross Domestic Product (GDP), correlate either positively or negatively. If a country's currency appreciates relative to another country's currency, bilateral trade between each country finds prices cheaper in the country with the weaker currency relative to the country with the stronger currency. Thus, imports into the country with the weaker currency are less expensive and more desirable, while exports from that country are more expensive and less desirable to consumers in the country with weaker currency (Taylor, 2001).

With the relative strength of a country's currency affecting importation and exportation of goods and services and market equilibrium adjustments providing needed flexibility (Kim, 1991), the extent that relative changes in currency exchange rates impact production within a country is a basis for this analysis. Relatively lower currency exchange rates that are favorable to exportation benefit producers of those goods and services that are exported, while relatively higher currency exchange rates benefit consumers of imported goods by stretching buying power. Prior research focuses heavily on exchange rate volatility as a dynamic explaining international transaction (Obstfeld & Rogoff, 1995). To the extent that international trade between the domestic and foreign country affects monetary policy, currency exchange rates are expected to correlate with macroeconomic policy goals that affect GDP.

This analysis considers the relative exchange rate relationship between the U.S. dollar and each currency of the four countries listed above. Examining if a statistically significant relationship exists between currency exchange rates and GDP involves considering the relative strength of two currencies over a period of years and measuring differences between changes in the two variables. This paper examines changes in annual current account balances, volatility of exchange rates vis-a-vis annual changes in the value of each country's currency relative to the U.S. dollar, annual changes in consumer prices, and economic openness of each country's markets in analyzing this relationship.

LITERATURE REVIEW

A theoretical basis for analyzing the relationship between currency exchange rates and GDP extends from several studies of currency exchange rates and their impact on bilateral trade and macroeconomic policies. Krugman, Baldwin, Bosworth, and Hooper (1987) logically examine the effects of currency exchange rates on international trade. Currency exchange rates that promote lower prices for imports lessen inflationary pressures in the economy and have a downward push on interest rates in that country. Conversely, currency exchange rates that make importation relatively more expensive (i.e. a depreciating currency) produce inflationary pressures and have an upward push on interest rates in the country with a depreciating currency. Exports experience opposite effects. A stronger currency that makes importation of goods and services relatively cheaper and thus more attractive makes exportation relatively less attractive. Exports from a country where the currency is relatively weak to a country where the currency is relatively strong are more attractive to consumers in the importing country (Mann, 2002).

The argument in studying a correlation rests on a premise that economic openness, which is a measure of the degree that free trade policy are encouraged, and real exchange rate volatility are inversely related. Higher degrees of trade integration are associated with more stable exchange rates and lower degrees of integration more volatility (Hau, 2002, pp. 611-612). That this phenomenon varies across countries is cause for investigation. Weak associations between exchange rate volatility and the volume of international trade exist, where volatility is representative of market inefficiencies (Kenen & Rodrik, 1986, p. 312; Koray & Lastrapes, 1989, p. 708). Nevertheless, exchange rate dynamics remain elusive (Evans, 2002; Dewenter, 1995). Flexible pricing of goods entering a country does not necessarily produce optimal exchange rates. Sticky prices that fail to adjust have monetary and fiscal policy implications (Obstfeld & Rogoff, 1995). But "openness puts a check on the government's incentive to engage in unanticipated inflation, because of induced exchange rate depreciation" (Terra, 1998, p. 641). The conditions under which movements in exchange rates produce higher welfare within a country are a function of price stickiness and risk sharing with long run and short run differences (Engel, 2001, p. 518). The implication is the extent that the import and export market exists and are allowed to flourish with an economy, the greater the effect of market forces in finding exchange rate equilibrium and the less likely firms will need to make short term pricing adjustments (Hau, 2002). "Firms respond with less of a price change to expected transitory real exchange rate movements than to expected permanent exchange rate movements" (Feinberg & Kaplan, 1992, p. 269), implying that for firms nominal changes in exchange rates have less of an effect on profit margins and pricing by domestic producers.

Terra's (1998) findings of an inverse relationship between economic openness and price levels offers important justification in utilizing changes in exchange rates to predict GDP. Not only are price levels important in examining expected movements in exchange rates, but also associations between the viability of a country's export market and GDP. An open economy and freely floating exchange rates assume predictable changes in output and inflation. Taylor (2001, p. 266) finds that such associations occur with a lag, however. That is an appreciation or depreciation of currency does not produce immediate results but rather increases the probability that monetary policy changes will occur as a result of these expectations (Feinberg & Kaplan, 1992, p. 267).

METHODOLOGY

The data for the sample were collected from the Federal Reserve Bank--St. Louis division (http://research.stlouisfed.org/fred2/) and United Nations statistical database (http://unstats.un.org/unsd/cdb/cdb_dict_xrxx.asp?def_code=63). The sample includes annual data for each variable coded as an absolute change in that variable. All variables in the model (with the exception of CPI data for 1975, 1976, and 1977 in Japan) were gathered for 1975-2004, inclusive, for a total of 30 observations.

Prior studies of currency exchange rates have focused on volatility and openness of the economy within a country. Considering each of these issues does not directly link to using exchange rates as a predictor of GDP, but offers a necessary indirect association for finding a correlation. While movements in exchange rates are considered in studies of macroeconomic principles (Taylor & Taylor, 2004; Dewenter, 1995), a dearth of research considers correlations between a country's economic output and movements of its exchange rate in search of market equilibrium. The model for this research considers four countries with which trading histories are well established and currency markets are well developed. Focusing on annual changes with the 30 years of the analysis, correlations between the variables are considered in measuring statistically significant correlations by using Pearson R. With Taylor (2001) finding exchange rate movements as a lagging indicator of changes in output the model compares concurrent changes in GDP with changes in GDP one year after changes in exchange rates. Comparisons are made to changes in GDP one year before changes in currency. Both future changes in GDP, as Taylor (2001) predicts, and laggard changes in GDP before changes in exchange rates are analyzed in this study.

Variables are chosen from studies by examining exchange rate studies conducted by Hau (2002), Mann (2002), and Terra (1998). Using the Pearson R, bivariate correlations between all variables in the model are measured for statistical significance at both .01 and .05 levels. Variables that are statistically significant with each other indicate an inverse correlation. Using multiple regression analysis those variables that are found to have a bivariate, statistical significance are analyzed in measuring a direct correlation between each independent variable and dependent variable.

If changes in GDP are not a function of changes in currency exchange rates, changes in GDP should be equal. The hypothesis for this study states that in comparing countries, those countries that experience greater changes in currency exchange rates also experience greater changes in levels of GDP one year after such changes in exchange rates. This two-tailed examination is stated as a research hypothesis (H1) such that changes in a country's GDP will not be affected by changes in currency exchange rates, or [Delta]GDP = [Delta]currency.

MODEL FORMULATION

Based on the review of the literature and the focus of this study to explore correlations between changes in currency exchange rates and changes in a country's GDP, the model is created as follows. Variables used in the model include currency exchange rates for the following countries from 1975 to 2004: Canadian Dollar (Canada), Japanese Yen (Japan), and Swedish Kroner (Sweden). The currency of each country is measured in terms of U.S. dollars. The currency exchange rate is measured as a ratio of the respective currency to the U.S. dollar and is an independent variable in analyzing changes in GDP in each of the respective countries. The variable is expressed as the change (expressed as [Delta]) in Canadian $ to U.S. $, [Delta] Japan Yen to U.S. $, and [Delta] Swedish Kronor to U.S. $, respectively, in measuring changes in currency exchange rates for Canada, Japan, and Sweden.

Other independent variables for each country in the model are annual changes in consumer prices, as measured through a Consumer Price Index (CPI); a measure of changes in import share of GDP in analyzing openness of trade markets; and changes in balances on the current account (BCA) for each country.

Changes in current account balances are expressed as increases or decreases in surplus or deficit based on the sign of the variable. A negative sign in the dataset indicates decreases in a current account surplus or increases in a current account deficit between two years; a positive sign indicates increases in the current account surplus or decreases in the current account deficit. The variables are listed as A Annual BCA for each of the countries, respectively.

GDP is the dependent variable in the model and changes are measured annually for Canada, Japan, Sweden, and the U.S. These variables are listed as [Delta] GDP (Canada), [Delta] GDP (Japan), [Delta] GDP (Sweden), and [Delta] GDP (U.S.), respectively. Analyzing changes in annual levels of GDP from the application of independent variables, the model seeks to answer to what extent the application of independent variables explains variability of a country's GDP. All annual changes for each independent and dependent variable are measured not as a percentage, but rather in absolute terms.

RESEARCH FINDINGS AND ANALYSES

Descriptive statistics for the respective variables for each country--Canada, Japan, Sweden, and the U.S.--are included in the model before considering leading or lagging effects of currency exchange changes. These statistics are an illustration of a concurrent measure of change for all variables associated with changes in exchange rates. Exchange rate data for the U.S. are omitted in that the currencies of each of the other countries are measured relative to the U.S. dollar, which represents the reserve currency in the model.

Table 1 shows descriptive statistics for each variable in the model before analyzing correlations when controlling for the other variables in Table 2, 3, and 4, everything else held constant. Tables 2, 3, and 4 present output for the regression analysis from those variables identified in Table 1.

Table 2 presents standardized coefficients of multiple regression results using annual changes in GDP in Canada, Japan, Sweden, and U.S. as the dependent variables and all other variables for currency exchange rates, consumer prices, and BCA as independent variables in separate analyses from each country. Values for the U.S. include changes in each of the three currencies, since each is measured relative to the U.S. dollar and the U.S. dollar is the reserve currency. Adjusted R-square for each output is listed below the independent variables.

In Table 3 the results of changes in annual levels of GDP for each country in the model are analyzed by applying changes in currency exchange rates one year prior to the change in level of GDP recorded. Standardized coefficients of multiple regression results using changes in GDP in Canada, Japan, Sweden, and U.S. as the dependent variables and all other variables for currency exchange rates, consumer prices, and BCA as independent variables in separate analyses form each country. Changes in currency exchange rates are applied one year prior to changes in GDP. Values for U.S. include changes in each of the three currencies, since each is measured relative to the U.S. dollar and the U.S. dollar is the reserve currency. Adjusted R-square is indicated below each output.

In Table 4 consideration of currency exchange rates as a lagging predictor of changes in GDP is presented. Standardized coefficients of multiple regression results using changes GDP in Canada, Japan, Sweden, and U.S. as the dependent variables and all other variables for currency exchange rates, consumer prices, and BCA as independent variables in separate analyses form each country. Changes in currency exchange rates are applied one year after changes in GDP. Values for U.S. include changes in each of the three currencies, since each is measured relative to the U.S. dollar and the U.S. dollar is the reserve currency. Adjusted R-square is indicated below each output.

Bivariate correlations find that changes in imports relative to GDP are universally statistically significant with changes in GDP, where such correlation exists. Changes in CPI and changes in BCA were inversely correlated with changes in GDP. For currency exchange rates, the only correlation that existed was between changes in the value of the Kronor relative to the U.S. dollar and the ratio of changes in imports into Sweden and GDP.

When currency exchange rates were analyzed by considering the effects of their movement as a leading and a lagging indicator of changes in GDP, the results were highly statistically insignificant. Applying the multiple effects of each independent variable to changes in GDP

found that changes in CPI remain a strong predictor of a country's GDP, with increases in the former associated with decreases in the latter. For the U.S. annual changes in BCA were negatively correlated with GDP, while imports as a percentage of GDP positively correlated. This association remains when considering exchange rates one year before or one year after changes in GDP. For each output in the model low coefficients of determination, or R-square, indicate that the variables in the model are not responsible for most of the changes in GDP.

Interestingly, change in the value of the Japanese Yen to the U.S. dollar is significant in predicting GDP in the U.S. one year after changes in exchange rates; this association is positive. That this association does not exist when exchange rates are considered as a lagging indicator suggests that Hau's (2002) analysis linking trade integration and exchange rate volatility deserves consideration when applied across countries.

With changes in currency exchange rates within each country in the model failing tests of statistical significance in predicting changes in that country's GDP, the model accepts the null hypothesis that changes in a country's GDP will not be affected by changes in currency exchange rates, or [Delta] GDP = [Delta] currency.

SUGGESTIONS FOR FUTURE RESEARCH

While a higher level of imports reflects an appreciating currency, an appreciating currency reduces inflationary pressures. Perhaps further study of price stickiness that Engel (2001) surmised holds part of the answer to exchange rate movements. Including additional variables in the model that address price levels and importation is an important step in explaining exchange rate--GDP associations.

CONCLUSION

This paper examines whether changes in currency exchange rates in a country are valid predictors of GDP. With relatively few prior studies on which to base a model of direct correlations between exchange rates and the economic output within a country this study borrowed from patterns of exchange rate volatility that Kenen and Rodrik (1986) analyze and openness of import markets that Terra (1998) closely links to protectionists patterns affecting exchange rates through price levels, which in turn affects GDP. Using 30 annual observations of changes in a country's GDP, changes in currency exchange rates, changes in price levels, changes in BCA, and changes in the quantity of imports as a percent of GDP, the model fails to identify a relationship between currency exchange rates and GDP, but finds associations that merit further attention. Change in CPI consistently inversely correlates with GDP, while change in imports as a share of GDP are positively related, supporting Feinberg and Kaplan's (1992) assertion that transitory exchange rate movements are less important to pricing levels than real exchange rate movements. A positive, statistically significant correlation between imports as a percent of GDP and greater GDP change is not surprising. What is surprising is that those countries that have experienced a statistically significant association between import ratios to GDP often experience similar inverse associations between CPI and GDP.

REFERENCES

Dewenter, K.L., (1995). Do exchange rate changes drive foreign direct investment? Journal of Business, 68(3), 405-433.

Engel, C., (2001). Optimal exchange rate policy: The influence of price setting and asset markets. Journal of Money, Credit and Banking, 33(2), 518-541.

Evans, M.D. (2002). FX trading and exchange rate dynamics. Journal of Finance, 57(6), 2405-2447.

Feinberg, R.M., & Kaplan, S. (1992). The response of domestic prices to expected exchange rates. Journal of Business, 65(2), 267-280.

Hau, H. (2002). Real exchange rate volatility and economic openness: Theory and evidence. Journal of Money, Credit and Banking, 34(3), 611-630.

Kenen, P.B., & Rodrik, D. (1986). Measuring and analyzing the effects of short-term volatility in real exchange rates. Review of Economics and Statistics, 68(2), 311-315.

Kim, Y. (1991). External adjustments and exchange rate flexibility: Some evidence from U.S. data. Review of Economics and Statistics, 73(1), 176-181.

Koray, F., & Lastrapes, W. D. (1989). Real exchange rate volatility and U.S. bilateral trade: A VAR approach. Review of Economics and Statistics, 71(4), 708-712.

Krugman, P.R., Baldwin, R.E., Bosworth, B.P., & Hooper, P. (1987). The persistence of the U.S. trade deficit. Brookings Papers on Economic Activity, 1987(1), 1-55.

Mann, C.L. (2002). Perspectives on the U.S. current account deficit and sustainability. Journal of Economic Perspectives, 16(3), 131-152.

Obstfeld, M., & Rogoff, K. (1995). Exchange rate dynamics redux. Journal of Political Economy, 103(3), 624-660.

Taylor, A.M., & Taylor, M.P. (2004). The purchasing power parity debate. Journal of Economic Perspectives, 18(4), 135-158.

Taylor, J.B. (2001). The role of the exchange rate in monetary-policy rules. American Economic Review, 91(2), 263267.

Terra, C.T. (1998). Openness and inflation: A new assessment. Quarterly Journal of Economics, 113(2), 641-648.

Benjamin B. Boozer Jr., Jacksonville State University

S. Keith Lowe, Jacksonville State University

Table 1: Descriptive Statistics for Country Concurrent
With Exchange Rates

Variable N Mean Std. Deviation

CANADA
[Delta] CPI 30 2.75 1.26
[Delta] BCA 30 857564667 6663246513
[Delta] Canadian $ to US$ 30 0.008 0.076
[Delta] GDP--Canada 30 16149929320 11822959766
[Delta] Imports to GDP 30 0.047 0.065
JAPAN
[Delta] CPI 30 1.63 1.89
[Delta] BCA 27 5968481481 22157321371
[Delta] Japan Yen to US$ 30 -6.55 22.4
[Delta] GDP 30 64568750360 47862482309
[Delta] Imports to GDP 30 .047 .113
SWEDEN
[Delta] CPI 30 2.860 1.850
[Delta] BCA 30 933,811,600 3,093,661,594
[Delta] Kronor to US$ 30 .084 .904
[Delta] GDP 30 4,874,624,326 4,275,527,333
[Delta] Imports to GDP. 30 .047 .115

UNITED STATES

[Delta] CPI 30 2.700 .986
[Delta] BCA 30 -22,232,933,333 46,471,781,432
[Delta] GDP 30 174,620,105,833 107,355,527,132
[Delta] Imports to GDP. 30 .061 .070

Table 2: Multiple Regression Output Measuring Current
Relationships Between Independent Variables and GDP

Country Standardized t Significance
 Coefficients level
CANADA
(Constant) 5.939 .000**
[Delta] Canadian $ to US$ -.134 -.850 .403
[Delta] Annual BCA--Canada .093 .603 .552
[Delta] Annual CPI--Canada -.575 -3.703 .001**
[Delta] Annual Imports .265 1.665 .108
 to GDP--Canada
 Adjusted R-square = 0.354
JAPAN
(Constant) 3.765 .001**
[Delta] Japan Yen to US$ -.059 -.298 .769
[Delta] Annual BCA--Japan -.179 -.855 .402
[Delta] Annual CPI--Japan .250 1.345 .192
[Delta] Annual imports .331 1.670 .109
 to GDP--Japan
 Adjusted R-square = 0.108

SWEDEN
(Constant) 5.165 .000**
[Delta] Swedish Kronor to US $ -.134 -.564 .578
[Delta] Annual BCA--Sweden .056 .315 .755
[Delta] Annual CPI--Sweden -.507 -3.114 .005**
[Delta] Annual imports .192 .847 .405
 to GDP--Sweden
 Adjusted R-square = 0.311
U.S.
(Constant) 4.923 .000**
[Delta] Swedish Kronor to US $ .010 .055 .956
[Delta] Canadian $ to US $ -.102 -.628 .536
[Delta] Japan Yen to US$ .120 .778 .444
[Delta] Annual BCA--US -.378 -2.462 .022*
[Delta] Annual CPI--US -.429 -2.671 .014*
[Delta] Annual imports .387 2.618 .015*
 to GDP--US
 Adjusted R-square = .556

* indicates significance at alpha = .05

** indicates significance at alpha = .01

Table 3: Multiple Regression Output With
Changes In Exchange Rates Applied One Year
Prior To Changes In GDP

Country Standardized t Significance
 Coefficients level

CANADA
(Constant) 5.720 .000 **
[Delta] Canadian $ to US$ -.246 -1.560 .131
[Delta] Annual BCA--Canada .154 .976 .339
[Delta] Annual CPI--Canada -.520 -3.440 .002 **
[Delta] Annual Imports .382 2.360 .027 *
 to GDP--Canada
 Adjusted R-square= 0.384

JAPAN
(Constant) 3.570 .002 **
[Delta] Japan Yen to US$ -.080 -.403 .691
[Delta] Annual BCA--Japan -.208 -.970 .343
[Delta] Annual CPI--Japan .272 1.418 .171
[Delta] Annual imports .306 1.443 .164
 to GDP--Japan
 Adjusted R-square = 0.111
SWEDEN
(Constant) 5.315 .000 **
[Delta] Swedish Kronor to US $ -.116 -.665 .513
[Delta] Annual BCA--Sweden .043 .246 .808
[Delta] Annual CPI--Sweden -.475 -2.864 .009 **
[Delta] Annual imports .265 1.603 .122
 to GDP--Sweden
 Adjusted R-square = 0.258
U.S.
(Constant) 5.319 .000 **
[Delta] Annual BCA--US -.339 -2.093 .048 *
[Delta] Annual CPI--US -.508 -2.995 .007 **
[Delta] Annual imports .410 2.673 .014 *
 to GDP--US
[Delta] Swedish Kronor to US $ -.138 -.768 .450
[Delta] Canadian $ to US $ .233 1.385 .180
[Delta] Japan Yen to US$ .326 2.102 .047 *
 Adjusted R-square = .526

* indicates significance at alpha = .05

** indicates significance at alpha = .01

Table 4: Multiple Regression Output With Changes In
Exchange Rates Applied One Year After Changes In GDP

 Standardized t Significance
 Coefficients level

CANADA
(Constant) 5.520 .000 **
[Delta] Canadian $ to US$ .036 .219 .829
[Delta] Annual BCA--Canada .096 .584 .565
[Delta] Annual CPI--Canada -.540 -3.404 .002 **
[Delta] Annual Imports .335 2.082 .048 *
 to GDP--Canada
 Adjusted R-square = 0.351
JAPAN
(Constant) 3.629 .001 **
[Delta] Japan Yen to US$ -.316 -1.662 .111
[Delta] Annual BCA--Japan -.205 -1.084 .290
[Delta] Annual CPI--Japan .315 1.751 .094
[Delta] Annual imports .212 1.060 .300
 to GDP--Japan
 Adjusted R-square = 0.204
SWEDEN
(Constant) 5.076 .000 **
[Delta] Swedish Kronor to US $ .195 1.036 .310
[Delta] Annual BCA--Sweden .124 .782 .442
[Delta] Annual CPI--Sweden -.486 -3.039 .006 **
[Delta] Annual imports .389 2.064 .050 *
 to GDP--Sweden
 Adjusted R-square = 0.33
U.S.
(Constant) 5.021 .000 **
[Delta] Swedish Kronor to US $ .036 .204 .840
[Delta] Canadian $ to US $ -.191 -1.100 .283
[Delta] Japan Yen to US$ -.167 -1.073 .295
[Delta] Annual BCA--US -.374 -2.236 .036 *
[Delta] Annual CPI--US -.429 -2.657 .014 *
[Delta] Annual imports .277 1.783 .088
 to GDP--US
 Adjusted R-square = .494

* indicates significance at alpha = .05

** indicates significance at alpha = .01