Applied Econometrics and International Development. AEID.Vol. 6-1 (2006)

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1 Applid Economtrics and Intrnational Dvlopmnt. AEID.Vol. 6-1 (2006) DETERMINANTS OF EXCHANGE RATE FLUCTUATIONS FOR VENEZUELA: APPLICATION OF AN EXTENDED MUNDELL-FLEMING MODEL HSING, u * Abstract Applying and xtnding th Mundll-Flming modl, this study attmpts to xamin th bhavior of short-trm ral xchang rats for Vnzula. It finds that th ral ffctiv xchang rat is positivly associatd with ral govrnmnt dficit spnding and ngativly influncd by ral M2, th world intrst rat, county risk, and th xpctd inflation rat. Hnc, th authoritis nd to xrcis fiscal disciplin so that dficit spnding would not b too larg to caus ral apprciation and hurt xports. Whn country risk riss du to th financial, conomic or political factors, ral xchang rats would dprciat. JEL Classification: F31, F41, O54 Ky words: Ral Effctiv Exchang Rat, Country Risk, World Intrst Rat, Montary Policy, Fiscal Policy 1. Introduction Th Vnzulan govrnmnt adoptd diffrnt xchang rat rgims ovr th last svral dcads. During 1973.M M1, th xchang rat was pggd at 4.29 or 4.30 bolivars pr U.S. dollar. During 1984.M M11, it was fixd at 7.50, and btwn 1986.M12 and 1989.M2 it was pggd to th dollar at During , th montary authoritis adoptd a complicatd four-tir xchang rat rgim that offrd subsidizd xchang rats to slctd priority activitis. By 1989.M3, th authoritis pursud a floating xchang rat systm basd on th supply of and dmand for th bolivar. As a rsult, th xchang rat sttld at in 1989.M3. Larg dvaluations occurrd in 1994.M5, 1996.M4, 2002.M2, 2002.M6, and 2003.M2 du to th dclin in crud oil prics, inflation, budgt dficits, political vnts, capital outflows, financial criss, or othr dvlopmnts. Th IMF providd an assistanc packag in April 1996 and rquird Vnzula to rais taxs and public srvic rats, dvalu th bolivar, incras th intrst rat, and incur mor dbt but did not addrss fundamntal structural rforms (Sucr, 1998). In July 1996, th authoritis attmptd to stabiliz th xchang rat by allowing a band of 7.5% dviation from th cntral parity on ithr dirction. Th authoritis would sll th U.S. dollar whn th bolivar was wak and buy th U.S. dollar and th bolivar was strong (Grubn and Kisr, 2002; Grubn and Darly, 2004). In Fbruary 2002, du to substantial losss of forign xchang rsrvs, dclining oil prics, dtriorating govrnmnt fiscal position, and vry high intrst rats, th authoritis announcd to * u Hsing is Profssor of Economics and had of th Dpartmnt of Gnral Businss in th Collg of Businss and Tchnology at Southastr Louisiana Univrsity, USA, Editor of th Intrnational Journal of Applid Economics and on of th contributors of th Study Guid for th Principls of Economics by Profssor N. Grgory Mankiw, -mail: yhsing@slu.du. 139

2 Applid Economtrics and Intrnational Dvlopmnt. AEID.Vol. 6-1 (2006) adopt a fr floating xchang rat and gav up th controlld band of allowing up to 10% dprciation pr yar (Lifshr, 2002). Sinc arly 2003, th authoritis hav priodically fixd th Bolivar/USD xchang rat at 1,598 in 2003.M2, 1,918 in 2004.M2, and 2,147 in 2005.M4. This papr applis and xtnds th Mundll-Flming modl (Mundll, 1968, 2001; Huh, 1999; Obstfld, 2001; Romr, 2001; Schrodr and Dornau, 2002; Mankiw, 2003) to xamin th rlationship btwn th ral ffctiv xchang rat for Vnzula and svral major macroconomic variabls. It is significant to study th bhavior of th xchang rat for Vnzula. Th bolivar has fluctuatd and dprciatd a grat dal ovr th yars. Undrstanding why xchang rats hav dprciatd considrably would hlp th authoritis in thir fforts to stabiliz th xchang rat. Som of th prvious studis prsntd diffrnt conclusions rgarding th bhavior of th Vnzulan xchang rat. Anoruo, Braha, and Ahmad (2002) applid th dynamic rror corrction modl to confirm th xistnc of purchasing powr parity for nin out of lvn countris including Vnzula. Bjornland (2004) maintaind that thr is no vidnc of purchasing powr parity for Vnzula and that purchasing powr parity should not b usd to masur any undr- or ovr-valuation of th ral xchang rat. If PPP is usd, it will ovr-stimat th ovrvaluation of th bolivar. Mankiw (2003) indicatd that a highr domstic intrst rat du to incrasd country risk is xpctd to rduc invstmnt spnding and shift IS * downward and may rduc or incras ral dmand for mony and shift LM * rightward or lftward. Hnc, th possibl nt impact of a highr domstic intrst rat du to incrasd country risk on th ral ffctiv xchang rat can b dtrmind mpirically. In th modl, thr ar thr simultanous quations including th goods markt quilibrium, th mony markt quilibrium, and aggrgat supply. In this study, comparativ-static analysis is applid to find th potntial impact of a chang in on of th xognous variabls on th quilibrium ral ffctiv xchang rat. Th Nwy-Wst (1987) mthod is mployd to yild htroskdasticity autocorrlation consistnt stimats for standard rrors and covarianc. 2. Th Modl Suppos that consumption spnding is a function of ral incom, govrnmnt tax, th ral intrst rat, that invstmnt spnding is dtrmind by ral output, th ral intrst rat, that nt xports ar influncd by th ral ffctiv xchang rat, that ral dmand for mony is a function of th nominal intrst rat and ral incom, and that th inflation rat is affctd by th xpctd inflation rat and th output gap, which is dfind as th diffrnc btwn th actual output and potntial output. Th opn macroconomic modl for Vnzula including th goods markt quilibrium, th mony markt quilibrium, and augmntd-xpctations aggrgat supply can b xprssd as: = C(, T, R + αγ π ) + I (, R + αγ π ) + G + NX( ε) (1) M = L( R + αγ, ) (2) 140

3 Hsing,. Dtrminants of xchang rat fluctuations for Vnzula whr C T R γ = ral GDP for Vnzula, = ral consumption spnding, = ral govrnmnt tax rvnus, = th world intrst rat, = country risk, * π = π + φ( ) (3) π = th xpctd inflation rat, I = ral invstmnt spnding, G = ral govrnmnt spnding, NX = nt xports, ε = th ral ffctiv xchang rat (an incras mans ral apprciation), M = ral mony supply, L = ral dmand for mony, π = th inflation rat, and * = potntial output. Not that th domstic intrst rat is a function of th world intrst rat and country risk or R + αγ and that α is a paramtr to indicat that th cofficints for th ral or nominal world intrst rat and country risk may hav diffrnt impacts on aggrgat xpnditurs and ral dmand for mony. Th ral ffctiv xchang rat is usd to provid th trad-wightd masur. Lt C L R+ αγ > 0, C G > 0, C > or < 0, L T < 0, C > 0, π R+ αγ π = φ > 0. < 0, I < 0, I R+ αγ π < 0, NX ε < 0, Solving for thr unknowns,ε, andπ, th quilibrium ral ffctiv xchang rat can b xprssd as * ε = ε ( M, G, T, R, γ, π ; φ, ). (4) Th rspctiv impacts of a chang in M and dficit spnding or G-T on ε ar givn by whr L NX > 0. J = ε ε / M = (1 C I )/ J < 0, (5) ( ε / G ε / T ) = [ L (1 C )]/ J > 0, (6) T 141

4 Applid Economtrics and Intrnational Dvlopmnt. AEID.Vol. 6-1 (2006) A highr world intrst rat is xpctd to caus ral dprciation du to its ngativ impacts on ral dmand for mony, consumption spnding, and invstmnt spnding: ε / R = [ L (1 C I ) + L ( C + I )]/ J < 0, (7) R As quation (8) shows, a highr country risk would caus ε to dprciat if ral dmand for mony rsponds ngativly to an incrasd country risk. On th othr hand, if ral mony dmand racts positivly to an incrasd country risk, a highr country risk may caus th quilibrium ral ffctiv xchang rat to dprciat or apprciat dpnding upon th rlativ magnitud of Lγ ( 1 C I ) and L ( C γ + Iγ ). R ε / γ = [ L (1 C I ) + L ( C + I )]/ J < 0. (8) 3. Data Sourcs and Empirical Rsults γ Th data wr obtaind from th Intrnational Financial Statistics publishd by th Intrnational Montary Fund. Th sampl priod rangs from 1989.Q2 to 2003.Q4. Th ral ffctiv xchang rat is an indx constructd by th IMF with 2000 as th bas yar. An incras mans ral apprciation. Ral M2 is chosn to rprsnt th ral quantity of mony and xprssd in billion bolivars. To rduc th dgr of multicollinarity, ral govrnmnt dficit spnding, D = (G T)/CPIx100, is usd and masurd in billion bolivars. Th 10-yar U.S. Trasury bond yild is chosn to rprsnt th world intrst rat. Country risk is masurd by th diffrnc btwn th lnding rat in Vnzula and th U.S. prim lnding rat (Mankiw, 2003). Th world intrst rat and country risk ar sparatd in mpirical work in ordr to considr th possibility that thir cofficints ar diffrnt. Th inflation rat is drivd from th prcnt chang in th CPI. Th xpctd inflation rat is th avrag inflation rat of past four quartrs. A binary variabl - B qual to 1 aftr 2002.Q1 and 0 othrwis is includd in th rgrssion du to th chang in th xchang rat rgims and substantial dvaluations of th bolivar. Excpt for zro or ngativ valus, th logarithmic scal is mployd in ordr to masur th lasticity of th ral ffctiv xchang rat with rspct to on of th right-hand sid variabls. In th ADF tst for unit roots, th critical valus ar -3.53, -2.91, and at th 1%, 5%, and 10% lvls. In lvls, th ral ffctiv xchang rat, ral M2, th 10-yar U.S. Trasury bond yild, and th xpctd inflation rat hav unit roots, and ral dficit spnding and country risk ar stationary at th 5% lvl. In first diffrnc, all th variabls ar stationary at th 5% lvl. In th ADF cointgration tst, th tst statistic is 4.19 compard with th critical valu of 3.77 at th 1% lvl. Hnc, th null hypothsis of no cointgrating rlationship can b rjctd, and ths variabls hav a stabl longtrm rlationship. Th lvl form is mployd in mpirical work bcaus diffrncing would caus th loss of important information and mak th outcoms obscur (Grn, 2003). γ R γ 142

5 Hsing,. Dtrminants of xchang rat fluctuations for Vnzula Th stimatd rgrssion and rlatd statistics ar prsntd in Tabl 1. Th Nwy- Wst (1987) mthod is applid in mpirical work to driv htroskdasticity and autocorrlation consistnt stimats for standard rrors and covarianc. As shown, approximatly 90.0% of th variation in th ral ffctiv xchang rat can b xplaind by th six right-hand sid variabls. Th stimatd cofficints ar significant at th 1% or 5% lvl. Th ral ffctiv xchang rat has a positiv rlationship with ral govrnmnt dficit spnding and a ngativ rlationship with ral M2, th world intrst rat, country risk, th xpctd inflation rat, and th binary variabl. Th Wald tst was prformd to dtrmin whthr th cofficints for th world intrst rat and country risk would b th sam. Th tst statistic is 8.31 with a 2 χ distribution and 1 dgr of frdom compard with th critical valu of 6.63 at th 1% lvl. Hnc, th null hypothsis that th two cofficints hav th sam valu can b rjctd. It implis that th ral ffctiv xchang rat is much mor snsitiv to a chang in th world intrst rat than to a chang in country risk. Svral commnts can b mad. An xpansionary montary policy incrasing ral quantity of mony supply would shift LM * to th right and lowr th ral ffctiv xchang rat. Bcaus mor govrnmnt dficit spnding would rais th ral ffctiv xchang rat and hurt nt xports, th govrnmnt nds to xrcis fiscal disciplin to monitor and rduc budgt dficit to th accptabl lvl. A rising world intrst rat is xpctd to shift IS * downward and LM * rightward and caus th ral ffctiv xchang rat to dclin. An analysis of th corrlation btwn ral M2 and country risk shows that thy hav a ngativ rlationship. Thrfor, a highr country risk would shift IS * downward and LM * rightward and lowr th ral ffctiv xchang rat. Svral othr masurs of th variabls wr considrd. Whn ral M1 rplacs ral M2, its cofficint bcoms insignificant mainly bcaus th broadr masur of mony is mor appropriat in xamining th bhavior of ral dmand for mony. Country risk is also masurd by th diffrntial of th dposit rats in Vnzula and th U.S. Th stimatd cofficint is significant at th 1% lvl and is stimatd to b compard with in Tabl 1, and th valu of R-squard is 91.1%. Th GARCH and ARCH modls (Franss, van Dijk and Lucas, 2004; Suliman, 2005) wr considrd and tstd. In th GARCH(1,1) modl, th cofficint of past rsidual varianc is insignificant at th 10% lvl. In th ARCH(1) modl, th cofficint of past squard rsidual is stimatd to b 1.206, which violats th assumption of lss than unity to hav stationarity. Th valu of R-squard is 86.7%, which is lowr than th valu of 90.0% in Tabl 1. To sav spac, ths rsults ar not prsntd hr and will b availabl upon rqust. 143

6 Applid Economtrics and Intrnational Dvlopmnt. AEID.Vol. 6-1 (2006) Tabl 1. Estimatd Rgrssion of th Ral Effctiv Exchang Rat for Vnzula Dpndnt Variabl: LOG( ε ) Mthod: Last Squars Sampl (adjustd): 1989.Q Q4 Includd obsrvations: 59 aftr adjustmnts Nwy-Wst HAC Standard Errors & Covarianc (lag truncation=3) Variabl Cofficint Std. Error t-statistic Prob. C LOG(M) D 4.30E E f LOG( R ) LOG( γ ) LOG( π ) B R-squard Man dpndnt var Adjustd R-squard S.D. dpndnt var S.E. of rgrssion Akaik info critrion Sum squard rsid Schwarz critrion Log liklihood F-statistic Durbin-Watson stat Prob(F-statistic) Summary and Conclusions This papr has xamind movmnts in th ral ffctiv xchang rat for Vnzula by applying and xtnding th Mundll-Flming modl. Th opn macroconomic modl including thr simultanous quations is applid. Svral major macroconomic variabls ar considrd to stimat thir potntial impacts on th quilibrium ral ffctiv xchang rat. Th Nwy-Wst mthod is mployd in mpirical work. Th rsults show that mor ral M2, lss dficit spnding, a highr world intrst rat, a highr country risk, and a highr xpctd inflation rat ar xpctd to caus th ral ffctiv xchang rat to dprciat. Hnc, mpirical rsults ar consistnt with th prdictions of th thortical modl. Rcntly, th world intrst rat has bn on th ris and would caus th ral xchang rat to dclin. To maintain th valu of th bolivar, Vnzula nds to rduc country risk by pursuing or maintaining political stability, conomic growth, a halthy financial markt, and othr propr masurs. Thr may b aras for futur rsarch. Country risk may b constructd in a diffrnt mannr. Th xpctd inflation rat may b stimatd using mor sophisticatd mthodologis. Othr potntial variabls may b considrd if th inclusion would not 144

7 Hsing,. Dtrminants of xchang rat fluctuations for Vnzula caus mpirical problms du to multicollinarity. Othr xchang rat modls (Sarno and Taylor, 2002; Sarno, Valnt, and rk, 2004) may b considrd. Bibliography Anoruo, E., Braha, H., and Ahmad,. (2002). Purchasing Powr Parity: Evidnc from Dvloping Countris. Intrnational Advancs in Economic Rsarch, 8(2), pp Bjornland, H. (2004). Estimating th Equilibrium Ral Exchang Rat in Vnzula. Economics Bulltin, 6(6), pp Dornbusch, R. (1998). Ral Exchang Rats and Macroconomics: A Slctiv Survy. National Burau of Economic Rsarch Working Papr: Franss, P. H., van Dijk, D., and Lucas, A. (2004) Short Patchs of Outlirs, ARCH and Volatility Modlling. Applid Financial Economics, 14(4), pp Grn, W. H. (2003), Economtric Analysis, fifth dition, Nw ork: Prntic Hall. Grubn, W. C. and Kisr, S. L. (2002). Vnzula Addrsss Economic Strss. Fdral Rsrv Bank of Dallas Southwst Economy, Issu 2, March/April, pp Grubn, W. C. and Darly, S. (2004). Th Curs' of Vnzula. Fdral Rsrv Bank of Dallas Southwst Economy, Issu 3, May/Jun, pp Huh, H.-S. (1999), How Wll Dos th Mundll-Flming Modl Fit Australian Data sinc th Collaps of Brtton Woods?. Applid Economics, 31(3), pp Lifshr, Marc. (2002). Vnzula to Shift to a Floating Rat Of Exchang for Its Bolivar Currncy. Wall Strt Journal (Eastrn dition), Fb 13, p. A.16. Mankiw, N. G. (2003). Macroconomics. Fifth dition. Nw ork: Worth. Mundll, R. A. (1968). Intrnational Economics. Nw ork: Macmillan. Mundll, R. A. (2001) On th History of th Mundll-Flming Modl: Kynot Spch. IMF Staff Paprs, 47(0), Spcial Issu, pp Nwy, W. K. and Wst, K. D. (1987). A Simpl, Positiv Smi-Dfinit, Htroskdasticity and Autocorrlation Consistnt Covarianc Matrix. Economtrica, 55(3), pp Obstfld, M. (2001). Intrnational Macroconomics: Byond th Mundll-Flming Modl. IMF Staff Paprs, Spcial Issu, 47, pp Obstfld, M. and Rogoff, K. (1996). Foundations of Intrnational Macroconomics, Cambridg, MA: MIT Prss. 145

8 Applid Economtrics and Intrnational Dvlopmnt. AEID.Vol. 6-1 (2006) Romr, D. (2001). Advancd Macroconomics, scond dition. Nw ork: McGraw Hill. Sachs, J. and Warnr, A. M. (2001). Th Curs of Natural Rsourcs. Europan Economic Rviw, 45(4-6), Sarno, L., Valnt, G., and rk, E. (2004). Montary Fundamntals and Exchang Rat Dynamics undr Diffrnt Nominal Rgims. Economic Inquiry, 42(2), Sarno, L. and Taylor, M. P. (2002). Th Economics of Exchang Rats. Cambridg: Cambridg Univrsity Prss. Schrodr, M. and Dornau, R. (2002). Do Forcastrs Us Montary Modls? An Empirical Analysis of Exchang Rat Expctations. Applid Financial Economics, 12(8), pp Sucr, A. J. (1998). Vnzula Can t Afford Any Mor Hlp from th IMF. Wall Strt Journal, August 14, p. 1. Suliman, O. (2005). Intrst Rat Volatility, Exchang Rats, and Extrnal Contagion. Applid Financial Economics, 15(12), pp Taylor, A. M. and Taylor, M. P. (2004). Th Purchasing Powr Parity Dbat. Journal of Economic Prspctivs, 18(4), pp Taylor, M. P. and Sarno, L. (1998). Th Bhavior of Ral Exchang Rats during th Post-Brtton Woods Priod. Journal of Intrnational Economics, 46(2), pp Journal publishd by th Euro-Amrican Association of Economic Dvlopmnt