MACROVARIABLES IN DETERMINING THE EXCHANGE RATE OF THE U.S. DOLLAR AND MAJOR CURRENCIES

INTRODUCTION The most well established theories of exchange rate determination are Purchasing Power Parity and Interest Rate Parity. If the absolute Purchasing Power Parity holds, this means that exchange rate is determined by relative prices in two countries and there would be no opportunity for arbitrage profit by speculating in the foreign exchange market. It has been found that although Purchasing Power Parity holds in the long run between the United States and other industrialized countries, Purchasing Power Parity does not hold between the United States and other developing countries. Therefore, there is reason to believe that exchange rate is determined not only by Purchasing Power Parity but there are other variables which are unique to each country for determining exchange rate. The absolute form of Purchasing Power Parity implies that if exchange rate changes deviates from PPP it affects the competitiveness of a country in international trade (Haque, 2003). Empirical studies failed to prove PPP holds, nevertheless, it remains a valid theory for Academicians and practitioners. If you are planning to take a job in Bangladesh, converting your U.S. salary into Bangladesh taka, it will not give you the true purchasing power, because cost of living in Bangladesh may be significantly lower. Most of the empirical study on Purchasing Power Parity has given negative results; therefore, this study tries to find what variables are important in determining exchange rate for each individual country. The results clearly indicate that even within the OECD and European Union countries there is significant difference in cost of living in different countries (Vachris & Thomas, 1999). The theory of Interest Rate Parity holds that one cannot make arbitrage profit by speculating in foreign exchange market due to different interest rate in different countries. Let us say for example that interest rate is 8 percent in the U.S. and 6 percent in U.K. Investors in U.K. will want to transfer funds to the U.S. to invest at the higher prevailing interest rate. Suppose they have a 3 month investment horizon, at the end of 3 months the pound will appreciate against the dollar. Because of the depreciation of the dollar, the U.K. investor will receive fewer pounds which will wipe out any gain made from the higher interest rate in the U.S. Therefore, the British investor will not be any better off by investing in the U.S. to take advantage of the higher interest rates. In order for the British investor to make any gain, the investor buys dollar in the spot market and sells dollar in the forward market. The opportunity to make this arbitrage profit will induce all British investors to buy dollar in the spot market and sell dollar in the forward market. This will cause an appreciation of the dollar in the spot market and depreciation of the dollar in the forward market until equilibrium is reached and arbitrage profit is wiped out. In a study it was found that although Interest Rate Parity holds for the most part between the U.S.A. and other industrialized countries, it does not hold between the U.S.A. and developing countries, therefore it is possible to make arbitrage profit in foreign exchange speculation through covered interest arbitrage (Haque, 2003). Uncovered Interest Rate Parity suggests that existence of different interest rates in different countries can be explained by expected changes in exchange rates, although, empirically this theory does not hold (Micheal & Christensen, 1999). Therefore, one could reasonable argue that there are other factors besides interest rates that influence exchange rate determination. Since it is found thus far that neither Purchasing Power Parity or Interest Rate Parity alone or combined determines exchange rates, there are other variables that are unique in determining exchange rates for different countries. This study was undertaken to determine whether the exchange rate of the dollar is dependent upon some macrovariables, especially against its major trading partners Canada, Europe, Japan and also the SDR. …

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