Analyzing Bilateral Currency Exchange Rates in Predicting Economic Output

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. …

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