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Application of Monetary Models of Exchange Rate Determination for Poland

Application of Monetary Models of Exchange Rate Determination for Poland T he zloty/U SD exchange rate is examined based on the D ornbusch model, the B ilson model, the F renkel model, and the F rankel model. E mpirical results show that the coefficient of the relative money supply is positive and significant, that the coefficient of the relative output is negative and significant, and that the B ilson model or the F renkel model applies to P oland. H ence, the nominal exchange rate is positively affected by the relative interest rate and the relative expected inflation rate. T he B alassa-S amuelson effect is confirmed in both models. T he B ilson model has a smaller root mean squared error or mean absolute percent error than the F renkel model. Keywords: Dornbusch model, Bilson model, Frenkel model, Frankel model, Balassa-Samuelson effect JEL: F31 DOI: 10.2478/v10033-008-0011-y 1. Introduction Since April 2000, Poland has pursued a floating exchange rate regim e without setting any restrictions against other foreign currencies. However, the National Bank of Poland, which is the central bank of Poland, reserves the right to take necessary m easures to intervene in the foreign exchange m arket in order to achieve the stated inflation target of 2.5% decided by the Monetary Policy Council, with an allowed deviation of 1 percentage point from either side and to m eet the criterion of exchange rate stability in order to join the Eurozone. According to International Financial Statistics, the zloty/ USD exchange rate fluctuated in the short run and exhibited trends in the long run, rising from 1.12 in 1992.M1 to a high of 4.64 in 2000.M10, and then declining to 3.09 in 2006. M10. These statistics suggest that the zloty has becom e stronger against the U.S. dollar in recent years. The study of the behavior of the zloty/USD exchange rate is significant for several reasons. Exchange rate stability is essential to the growth of international trade. Rapid appreciation of the zloty is expected to hurt exports and help im ports, whereas rapid depreciation would help exports and hurt im ports. Although depreciation would help exports, depreciation is expected to cause im port prices and dom estic inflation rates to rise. Currency depreciation m ay lead to a decrease in real wealth or assets, capital outflows, less foreign investm ents, potential problem s of repaym ent of foreign debt, etc. Hence, the study of the behavior of the nom inal exchange rate is significant. Several recent articles studied the exchange rates for Poland and other countries in the region. Dibooglu and Kutan (2001) revealed that real exchange rate fluctuations in Poland and Hungary can be significantly explained by nom inal shocks and that real shocks exerted m ore effect on the exchange rates in Hungary than in Poland. Sm idkova, Barrell and Holland (2003) found evidence of overvaluation for Poland and the other three pre-accession countries in 2001 and that econom ic fundam entals m ay not necessarily lead to the stability of the real exchange rate. Karfakis and Moschos (2004) showed that m acroeconom ic fundam entals largely contributed to currency crises in Poland and the Czech Republic. Creel and Levasseur (2004) indicated that that governm ent actions and m easures were m ore credible in Poland than the other two countries *Hsing: Southeastern Louisiana University Ham m ond, LA 70402,USA e-m ail: yhsing@selu.edu under study. Barlow (2004) found that the purchasing power parity hypothesis was rejected in Poland, the Czech Republic, and other selected developed countries. CrespoCuaresm a, Fidrm uc, and MacDonald (2005) found that the m onetary m odel com bined with the Balassa-Sam uelson effect worked well in explaining exchange rate behaviors for six CEECs. Stavarek (2005) reported that stock prices Granger-caused the exchange rates in Poland, the Czech Republic, Hungary, and Slovakia. This paper attem pts to exam ine the nom inal exchange rate for Poland based on several well-known m onetary m odels (Frenkel and Koske, 2004) including the Dornbusch m odel (1976), the Bilson m odel (1978), the Frenkel m odel (1976), and the Frankel m odel (1979). Monetary m odels of exchange rate determ ination are based on purchasing power parity, interest parity, and the m oney dem and function. The purchasing power parity hypothesis assum es that the nom inal exchange rate is a function of the relative price in the two countries under study. The interest parity concept postulates that the nom inal exchange rate is determ ined by the interest rate differential between the two countries. Stable m oney dem and functions for the two countries are expected in deriving a stable exchange rate equation. There are several versions of m onetary m odels of exchange rate determ ination, partly depending upon whether a sticky price (Dornbusch, 1976; Frankel, 1979) or a flexible price (Frenkel, 1976; Bislon, 1978) is assum ed. Monetary m odels of the exchange rate have been studied extensively. MacDonald and Taylor (1991, 1993, 1994a, 1994b), Kouretas (1997), Diam andis, Georgoutos and Kouretas (1998), Makrydakis (1998), Husted and MacDonald (1998), Reinton and Ongena (1999), Chinn (1999, 2000), Miyakoshi (2000), Hwang (2001), Tawadros (2001), Civcir (2003), Sarno, Valente, and Wohar (2004), Lee, Azali and Matthews (2007), Bitzenis and Marangos (2007), and others have found evidence in support of the m onetary m odels for som e currencies. To m easure the potential im pact of the productivity differential in the tradable and non-tradable sectors on the nom inal exchange rate, the Balassa-Sam uelson effect (Balassa, 1964; Sam uelson, 1964; Chinn, 1999, 2000; Drine and Rault, 2005; CrespoCuaresm a, Fidrm uc, and MacDonald, 2005; Lothian and Taylor, 2006) will be tested. where = the nom inal exchange rate in term s of the zloty per U.S. dollar, = the m oney supply for Poland, = real output for Poland = the short-term nom inal interest rate for Poland M Y R = the expected inflation rate for Poland M*= the m oney supply for the U.S. Y* = real output for the U.S. R* = the short-term nom inal interest rate for the U.S. = the expected inflation rate for the U.S. = error term s. The coefficient of the relative m oney supply is expected to be positive and equal to one, and the coefficient of the relative output is expected to be negative. Different assum ptions of these four m odels are as follows: The Dornbusch m odel: < 0, > 0, = 0, =0 =0 >0 The Bilson m odel: The Frenkel m odel: The Frankel m odel: < 0, >0 2. The Model Supposing that the purchasing power parity hypothesis holds, that is, that m oney dem and functions are stable for both countries, and/or that the uncovered interest parity condition is valid, the four different m onetary m odels of the nom inal exchange rate can be described by the following equation with different assum ptions on the param eters: + 1 (M - M * ) - (Y - Y * ) + 3 ( R - R * ) + )+ (1) Therefore, the Dornbusch m odel assum es that an increase in the relative interest rate would cause the zloty to appreciate because a higher dom estic interest rate relative to the foreign interest rate would lead to capital inflows and higher dem and for the zloty. The Bilson m odel postulates that an increase in the relative interest rate would cause the zloty to depreciate because the dem and for dom estic currency would decline in response to a higher dom estic interest rate relative to the foreign interest rate. The Frenkel m odel m aintains that an increase in the relative expected inflation rate would lead to the depreciation of the zloty. The Frankel m odel com bines the assum ptions of the Dornbusch m odel and the Frenkel m odel. Note that the Dornbusch and Frankel m odels assum e that uncovered interest parity holds and that purchasing power parity holds in the long run. The expected exchange rate change is a function of the interest rate differential or is the deviation of the spot rate from its long-term rate plus the deviation of the actual inflation rate from the expected inflation rate. In other words, the long-term exchange rate is equal to the short-term exchange rate plus the real interest rate differential. The Balassa-Sam uelson effect can be tested by adding another variable to the first equation: e * * * - 0 + 1 ( M - M ) - 2 (Y - Y ) + 3 ( R - R ) + 4 ( N N ) + 5 (PT - PT ) + ( value of 95.754, the null hypothesis of no cointegration cannot be rejected at the 5% level. According to the Granger causality test, Granger cause each other, and Granger cause each other. or PTN Y -Y* * - PTN * and Y - Y and (2) where PTN is the log difference between the tradable sector price and non-tradable sector price in Poland and PTN - PTN * but not vice versa. M - M * Granger PTN * is the log difference between the tradable sector price and non-tradable sector price in the U.S. - Y * , e - e , or PTN - PTN * but not vice * * versa. R - R Y - Y but not vice versa. causes Y - - Y - Y * but not vice versa. 3. Empirical Results Monthly data were collected from International Financial Statistics, which is published by the International Monetary Fund. The sam ple ranges from 1992.M1 to 2005.M12 for the Dornbusch or Bilson m odel and from 1992.M6 to 2005. M12 for the Frenkel or Frankel m odel to account for lags in constructing the expected inflation rate. The data for the m oney supply beyond 2005.M12 had not been published at the tim e of writing. The exchange rate is expressed as zlotys per U.S. dollar.1 M2 m oney is used for the m oney supply and is expressed in m illions for Poland and billions for the U.S. Industrial production is selected to represent output as data for real GDP are not available on a m onthly basis.2 The m oney m arket rate in Poland and the federal funds rate in the U.S. are chosen to represent the interest rates. The average inflation rate of the past four m onths is used to represent the expected inflation rate.3 The tradable sector price is represented by the producer price index, and the non-tradable sector price is represented by the consum er price index.4 Except for the interest rates and expected inflation rates, all other variables are m easured in the logarithm ic scale. In the unit root test, the critical values are -3.468, -2.878, and -2.576 at the 1%, 5%, and 10% levels. All the variables have unit roots in levels and are stationary in first difference at the 5% level. According to the Johansen test, in equation (1), because the value of the trace statistic is estim ated to be 125.563 com pared with the critical value of 69.819, the null hypothesis that the exchange rate and other variables in equation (1) are not cointegrated cannot be rejected at the 5% level. In a sim ilar m anner, in equation (2), because the trace statistic of 159.091 is greater than the critical 1. The EUR/PLN exchange rate m ay be considered due to its increasing significance after joining the EU. However, the earliest data for the EUR/PLN exchange rate begin in 1999. The sam ple size m ay not be large enough to test m onetary m odels. 2. Ideally, real GDP instead of industrial production should be used in em pirical work. However, real GDP is reported on a quarterly basis, whereas industrial production is reported on a m onthly basis. If real GDP is used in em pirical work, the sam ple size will reduce by 75%, m aking the test of hypotheses m ore unreliable. 3. Consum er inflation expectations published by the NBP m ay be em ployed. However, num erical values were not readily available. Furtherm ore, the series ended in 2002.M12, which would reduce 36 observations in the sam ple. 4. The selection of the PPI and CPI to represent the price levels for the tradable and non-tradable goods m ay not reflect the changing com position of the service sector. R - R * e e but not vice versa. but not vice versa. PTN - PTN * Notes: Figures in the parenthesis are t-ratios. The critical values at the 1%, 2.5%, 5%, and 10% significance levels are 2.364, 1.984, 1.660, and 1.290, respectively. PTN is the log difference between the tradable sector price and non-tradable sector price in Poland. PTN * is the log difference between the tradable sector price and non-tradable sector price in the U.S. Table 1. Estimated Regressions of the Nominal Exchange Rate for Poland Table 1 presents estim ated regressions for different m odels and related statistics. The level form is em ployed in em pirical work because the use of first-difference m ay obscure the outcom e (Greene, 2003). The Newey-West (1987) m ethod is applied to yield consistent estim ates for the standard error and covariance when the form s of autocorrelation and heteroskedasticity are uncertain. In version (A), the positive coefficient of the relative m oney supply and the negative coefficient of the relative output are as expected and are significant at the 1% level. The positive and significant coefficient of the relative interest rate suggests that the behavior of the exchange rate in Poland can be characterized by the Bilson m odel better than the Dornbusch m odel. It im plies that an increase in the relative interest rate is expected to cause the zloty to depreciate. In version (B), the Frenkel m odel is tested. The coefficients of the relative m oney supply and the relative output have the expected signs and are significant. The positive and significant coefficient of the relative expected inflation rate indicates that an increase in the relative expected inflation rate would cause the zloty to depreciate. In version (C), the Frankel m odel is tested. The coefficients of the relative m oney supply and the relative output have the expected signs and are significant. The positive and significant coefficient of the relative interest rate is opposite to the assum ption of the Frankel m odel. The coefficient of the relative expected inflation rate is positive but insignificant. In every version the null hypothesis that 1 = 1 can be rejected at the 5% level. The root m ean squared error is used to determ ine which m odel would perform better in forecasting. The root m ean squared error is 0.229 in the Bilson m odel and 0.241 in the Frenkel m odel. The m ean absolute percent error is 5.673% in the Bilson m odel and 5.760% in the Frenkel m odel. Hence, the Bilson m odel has sm aller forecast errors than the Frenkel m odel. To m easure the effect of the productivity differential in the tradable and non-tradable sectors on the exchange rate, the Balassa-Sam uelson (1964) effect is tested. The coefficient of the relative price of the tradable to nontradable goods is positive and significant at the 1% level in the Bilson m odel in version (D) and in the Frenkel m odel in version (E) in Table 1. The Balassa-Sam uelson effect is not tested in the Frankel m odel because of an incorrect sign for the coefficient of the relative interest rate. The error correction m odel with a lag length of two is considered. In versions (B), (C), and (E), the coefficient of the error correction term is insignificant at the 10% level. In version (A), the coefficient of the error correction term is negative and significant, ( has a significant t -1 ) coefficient with a positive value, and all other coefficients are insignificant. In version (D), ( t -1 ) and ( t - 2 ) have significant coefficients, and all other coefficients are insignificant. To save space, details of the results are not printed here and will be available upon request. To account for a possible im pact of the adoption of a floating exchange rate policy since April 2000, a dum m y variable with a value of zero before April 2000 and one since April 2000 has been considered. The coefficient of the dum m y variable is positive but insignificant at the 10% level in the Dornbusch m odel, the Bilson m odel, the Frenkel m odel, and the Frankel m odels, and it is positive and significant at the 2.5% level in the regressions with the Balassa-Sam uelson effect. These results suggest that the pursuit of a floating exchange rate m ay lead to a depreciation of the zloty, holding other factors constant. Several different m easurem ents or versions are considered. Treasury bill rates in Poland and the U.S. m ay be considered to represent the relative interest rate. However, the data of the Treasury bill rate in Poland are not com plete. Real GDP m ay substitute industrial production in em pirical work. However, the sam ple size based on quarterly data will decrease 75%, causing hypothesis tests to becom e less reliable. Attem pts were m ade to include the relative stock price in the m odels without success due to the lack of com plete data for the stock price in Poland during the sam ple period. To save space, these results are not presented and will be available upon request. 4. Summary and Conclusions This paper has exam ined the exchange rate behavior for Poland based on four well-known m odels. Em pirical results show that the Bilson m odel and the Frenkel m odel characterize the behavior of the nom inal exchange rate for Poland better than the Dornbusch m odel and the Frankel m odel. The positive and significant coefficient of the relative interest rate in the Bilson m odel indicates that raising the dom estic interest rate relative to the foreign interest rate would cause the zloty/USD exchange rate to rise or the zloty to depreciate. The positive and significant coefficient of the relative expected inflation rate in the Frenkel m odel suggests that a higher expected dom estic inflation rate relative to the expected foreign inflation rate would cause the zloty to depreciate or the zloty/USD exchange rate to rise. The m onetary m odels can explain the behavior of the zloty/USD exchange rate reasonably well in view of a relatively high value of R2 and a relatively sm all value of the root m ean squared error or the m ean absolute percent error. There are several policy im plications. The Bank of Poland needs to m onitor its m oney supply. Increased m oney supply in Poland relative to the m oney supply in the U.S. would cause the zloty to depreciate. Contrary to what m any countries have been practicing, raising the dom estic interest rate relative to the U.S. interest rate would not help to appreciate the zloty against the U.S. dollar. A higher interest rate hurts consum ption and investm ent spending and would cause the zloty to depreciate even though it would cause international capital inflows and increase the dem and for the zloty. Maintaining price stability and a low inflation rate would help protect the value of the zloty. The positive and significant coefficient of the relative tradable to non-tradable prices m ay suggest that productivity differential is im portant in the determ ination of the nom inal exchange rate. There m ay be potential areas for future research. The m onetary m odels are based on the assum ptions of a stable m oney dem and function and the validity of purchasing power parity and uncovered interest parity. It m ay be interesting to study whether the m oney dem and functions for Poland and the U.S. would be stable. The m onetary m odels m ay be com pared with other exchange rate m odels such as the one based on an open econom y IS, the m onetary policy function, and an augm ented Phillips curve (Rom er, 2006). In this exchange rate m odel, the central bank determ ines the short-term interest rate based on the inflation rate gap, the output gap, and other related variables such as the exchange rate and the world interest rate. If currency depreciation leads to a higher inflation rate, the central bank would raise the interest rate, which, in turn, is expected to reduce aggregate spending and output. Drine, I. and Rault, C. 2005. Can the Balassa-Sam uelson theory explain long-run real exchange rate m ovem ents in OECD countries? Applied Financial Econom ics, 15, 519-30. Frankel, J. A. 1979. On the m ark: a theory of floating exchange rates based on real interest differentials, Am erican Econom ic Review, 69, 610-22. Frenkel, M. and Koske, I. 2004. How well can m onetary factors explain the exchange rate of the euro?, Atlantic Econom ic Journal, 32, 232­43. Frenkel, J. A. 1976. A m onetary approach to the exchange rate: doctrinal aspects and em pirical evidence, Scandinavian Journal of Econom ics, 78, 200-24. Fuhrer, J. C. and Weiller, K. J. 1991. Multivariate posterior odds approach to assessing com peting exchange rate m odels, Review of Econom ics & Statistics, 73, 113-24. Greene, 2003. Econom etric Analysis, 5th edition, Upper Saddle River, New Jersey. Hooper, P. and Morton, J. E. 1982. Fluctuations in the dollar: a m odel of nom inal and real exchange rate determ ination, Journal of International Money and Finance, 1, 39-56. Husted, S. and MacDonald, R. 1998. Monetary-based m odels of the exchange rate: a panel perspective, Journal of International Financial Markets, Institutions and Money, 8, 1-19. Hwang, J. K. 2001. Dynam ic forecasting of m onetary exchange rate m odels: evidence from cointegration, International Advances in Econom ic Research, 7, 51­64. Karfakis, C., and D. Moschos 2004. Predicting currency crises: evidence from two transition Econom ies, Em erging Markets Finance and Trade, 40, 95-103. Kouretas, G. P. 1997. Identifying linear restrictions on the m onetary exchange rate m odel and the uncovered interest parity: cointegration evidence from the Canadian US dollar, Canadian Journal of Econom ics, 30, 875­90. Lobo, B. J. 2002. Large changes in m ajor exchange rates: a chronicle of the 1990s, Applied Financial Econom ics, 12, 805-11. Lothian, J. R. and Taylor, M. P. 2006. Real exchange rates over the past two centuries: how im portant is the Harrod-Balassa-Sam uelson effect? University of Warwick, Departm ent of Econom ics, Warwick Econom ics Research Paper Series (TWERPS). R eferences Barlow, D. 2004. Purchasing power parity in three transition economies, Economics of Planning, 36, 201-21. Bilson, J. F. O. 1978. Rational expectations and the exchange rate, in: J. Frenkel and H. Johnson, eds., The Economics of Exchange Rates, Addison-Wesley Press, Reading. Bitzenis, A. and Marangos, J. 2007. The monetary model of exchange rate determination: the case of Greece (1974-1994), International Journal of Monetary Economics and Finance, 1, 57-88. Cheung, Y.-W., Chinn, M. D. and Pascual, A. G. 2005. Empirical exchange rate models of the nineties: are any fit to survive? Journal of International Money and Finance, 24, 1150-75. Chinn, M. D. 1999. On the won and other East Asian currencies, International Journal of Finance and Economics, 4, 113-27. Chinn, M. D. 2000. Before the fall: were East Asian currencies overvalued? Emerging Markets Review, 1, 101-26. Civcir, I. 2003. The monetary models of the Turkish Lira/dollar exchange rate: long-run relationships, short-run dynamics and forecasting, Eastern European Economics, 41, 43­69. Crespo-Cuaresma, J., Fidrmuc, J., and MacDonald, R. 2005. The monetary approach to exchange rates in the CEECs, Economics of Transition, 13, 395-416. Diamandis, P. F., Georgoutos, D. A. and Kouretas, G. P. 1998. The monetary approach to the exchange rate: long-run relationships, identification and temporal stability, Journal of Macroeconomics, 20, 441­66. Dibooglu, S., and Kutan, A. M. 2001. Sources of real exchange rate fluctuations in transition economies: the case of Poland and Hungary, Journal of Comparative Economics, 29, 257-75. Dornbusch, R. 1976. Expectations and exchange rate dynam ics, Journal of. Political Econom y, 84, 1161-76. MacDonald, R. and Taylor, M. P. 1991. The m onetary approach to the exchange rate: long-run relationships and coefficient restrictions, Econom ics Letters, 37, 179­85. MacDonald, R. and Taylor, M. P. 1992. Exchange rate economics, IMF Staff Paper, 39, 437­89. MacDonald, R. and Taylor, M. P. 1993. The monetary approach to the exchange rate: rational expectations, long-run equilibrium, and forecasting, IMF Staff Papers, 40, 89­107. MacDonald, R. and Taylor, M. P. 1994a. The monetary model of the exchange rate: long-run relationships, short-run dynamics and how to beat a random walk, Journal of International Money and Finance, 13, 276­90. MacDonald, R. and Taylor, M. P. 1994b. Re-examing the monetary approach to the exchange rate: the dollar­franc, 1976­90, Applied Financial Economics, 4, 423­9. Meese, R. A. and Rogoff, K. 1983. Empirical exchange rate models of the seventies: do they fit out of sample? Journal of International Economics, 14, 3-24. Makrydakis, S. 1998. Testing the long-run validity of the monetary approach to the exchange rate: the won-US dollar case, Applied Economics Letters, 5, 507-11. Miyagawa, T., Toya, H., and Makino, T. 2004. Equilibrium exchange rates in Asian currencies, Seoul Journal of Economics, 17, 483-509. Miyakoshi, T. 2000. The Monetary Approach to the Exchange Rate: Empirical Observations from Korea, Applied Economics Letters, 7, 791-94. Newey, W. K. and West, K. D. 1987. A simple, positive semidefinite, heteroskedasticity and autocorrelation consistent covariance matrix, Econometrica, 55, 703-8. Reinton, H. and Ongena, S. 1999. Out-of-sample forecasting performance of single equation monetary exchange rate models in Norwegian currency markets, Applied Financial Economics, 9, 545-50. Romer, D. 2006. Advanced Macroeconomics, 3rd edition. Boston: McGraw-Hill/Irwin. Sarno, L., Valente, G., and Wohar, M. E. 2004. Monetary fundamentals and exchange rate dynamics under different nominal regimes, Economic Inquiry, 42, 179-93. Schroder, M. and Dornau, R. 2002. Do forecasters use monetary models? an empirical analysis of exchange rate expectations, Applied Financial Economics, 12, 535-43. Smidkova, K., R. Barrell, and D. Holland 2003. Estimates of fundamental real exchange rates for the five EU pre-accession countries, Prague Economic Papers, 12, 291-16. Tawadros, G. B. 2001. The predictive power of the monetary model of exchange rate determination, Applied Financial Economics, 11, 279­86. Taylor, M. P. 1995. The economics of exchange rates, Journal of Economic Literature, 33, 13­47. Taylor, A. M. and Taylor, M. P. 2004. The purchasing power parity debate, Journal of Economic Perspectives, 18, 135-58. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png South East European Journal of Economics and Business de Gruyter

Application of Monetary Models of Exchange Rate Determination for Poland

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Abstract

T he zloty/U SD exchange rate is examined based on the D ornbusch model, the B ilson model, the F renkel model, and the F rankel model. E mpirical results show that the coefficient of the relative money supply is positive and significant, that the coefficient of the relative output is negative and significant, and that the B ilson model or the F renkel model applies to P oland. H ence, the nominal exchange rate is positively affected by the relative interest rate and the relative expected inflation rate. T he B alassa-S amuelson effect is confirmed in both models. T he B ilson model has a smaller root mean squared error or mean absolute percent error than the F renkel model. Keywords: Dornbusch model, Bilson model, Frenkel model, Frankel model, Balassa-Samuelson effect JEL: F31 DOI: 10.2478/v10033-008-0011-y 1. Introduction Since April 2000, Poland has pursued a floating exchange rate regim e without setting any restrictions against other foreign currencies. However, the National Bank of Poland, which is the central bank of Poland, reserves the right to take necessary m easures to intervene in the foreign exchange m arket in order to achieve the stated inflation target of 2.5% decided by the Monetary Policy Council, with an allowed deviation of 1 percentage point from either side and to m eet the criterion of exchange rate stability in order to join the Eurozone. According to International Financial Statistics, the zloty/ USD exchange rate fluctuated in the short run and exhibited trends in the long run, rising from 1.12 in 1992.M1 to a high of 4.64 in 2000.M10, and then declining to 3.09 in 2006. M10. These statistics suggest that the zloty has becom e stronger against the U.S. dollar in recent years. The study of the behavior of the zloty/USD exchange rate is significant for several reasons. Exchange rate stability is essential to the growth of international trade. Rapid appreciation of the zloty is expected to hurt exports and help im ports, whereas rapid depreciation would help exports and hurt im ports. Although depreciation would help exports, depreciation is expected to cause im port prices and dom estic inflation rates to rise. Currency depreciation m ay lead to a decrease in real wealth or assets, capital outflows, less foreign investm ents, potential problem s of repaym ent of foreign debt, etc. Hence, the study of the behavior of the nom inal exchange rate is significant. Several recent articles studied the exchange rates for Poland and other countries in the region. Dibooglu and Kutan (2001) revealed that real exchange rate fluctuations in Poland and Hungary can be significantly explained by nom inal shocks and that real shocks exerted m ore effect on the exchange rates in Hungary than in Poland. Sm idkova, Barrell and Holland (2003) found evidence of overvaluation for Poland and the other three pre-accession countries in 2001 and that econom ic fundam entals m ay not necessarily lead to the stability of the real exchange rate. Karfakis and Moschos (2004) showed that m acroeconom ic fundam entals largely contributed to currency crises in Poland and the Czech Republic. Creel and Levasseur (2004) indicated that that governm ent actions and m easures were m ore credible in Poland than the other two countries *Hsing: Southeastern Louisiana University Ham m ond, LA 70402,USA e-m ail: yhsing@selu.edu under study. Barlow (2004) found that the purchasing power parity hypothesis was rejected in Poland, the Czech Republic, and other selected developed countries. CrespoCuaresm a, Fidrm uc, and MacDonald (2005) found that the m onetary m odel com bined with the Balassa-Sam uelson effect worked well in explaining exchange rate behaviors for six CEECs. Stavarek (2005) reported that stock prices Granger-caused the exchange rates in Poland, the Czech Republic, Hungary, and Slovakia. This paper attem pts to exam ine the nom inal exchange rate for Poland based on several well-known m onetary m odels (Frenkel and Koske, 2004) including the Dornbusch m odel (1976), the Bilson m odel (1978), the Frenkel m odel (1976), and the Frankel m odel (1979). Monetary m odels of exchange rate determ ination are based on purchasing power parity, interest parity, and the m oney dem and function. The purchasing power parity hypothesis assum es that the nom inal exchange rate is a function of the relative price in the two countries under study. The interest parity concept postulates that the nom inal exchange rate is determ ined by the interest rate differential between the two countries. Stable m oney dem and functions for the two countries are expected in deriving a stable exchange rate equation. There are several versions of m onetary m odels of exchange rate determ ination, partly depending upon whether a sticky price (Dornbusch, 1976; Frankel, 1979) or a flexible price (Frenkel, 1976; Bislon, 1978) is assum ed. Monetary m odels of the exchange rate have been studied extensively. MacDonald and Taylor (1991, 1993, 1994a, 1994b), Kouretas (1997), Diam andis, Georgoutos and Kouretas (1998), Makrydakis (1998), Husted and MacDonald (1998), Reinton and Ongena (1999), Chinn (1999, 2000), Miyakoshi (2000), Hwang (2001), Tawadros (2001), Civcir (2003), Sarno, Valente, and Wohar (2004), Lee, Azali and Matthews (2007), Bitzenis and Marangos (2007), and others have found evidence in support of the m onetary m odels for som e currencies. To m easure the potential im pact of the productivity differential in the tradable and non-tradable sectors on the nom inal exchange rate, the Balassa-Sam uelson effect (Balassa, 1964; Sam uelson, 1964; Chinn, 1999, 2000; Drine and Rault, 2005; CrespoCuaresm a, Fidrm uc, and MacDonald, 2005; Lothian and Taylor, 2006) will be tested. where = the nom inal exchange rate in term s of the zloty per U.S. dollar, = the m oney supply for Poland, = real output for Poland = the short-term nom inal interest rate for Poland M Y R = the expected inflation rate for Poland M*= the m oney supply for the U.S. Y* = real output for the U.S. R* = the short-term nom inal interest rate for the U.S. = the expected inflation rate for the U.S. = error term s. The coefficient of the relative m oney supply is expected to be positive and equal to one, and the coefficient of the relative output is expected to be negative. Different assum ptions of these four m odels are as follows: The Dornbusch m odel: < 0, > 0, = 0, =0 =0 >0 The Bilson m odel: The Frenkel m odel: The Frankel m odel: < 0, >0 2. The Model Supposing that the purchasing power parity hypothesis holds, that is, that m oney dem and functions are stable for both countries, and/or that the uncovered interest parity condition is valid, the four different m onetary m odels of the nom inal exchange rate can be described by the following equation with different assum ptions on the param eters: + 1 (M - M * ) - (Y - Y * ) + 3 ( R - R * ) + )+ (1) Therefore, the Dornbusch m odel assum es that an increase in the relative interest rate would cause the zloty to appreciate because a higher dom estic interest rate relative to the foreign interest rate would lead to capital inflows and higher dem and for the zloty. The Bilson m odel postulates that an increase in the relative interest rate would cause the zloty to depreciate because the dem and for dom estic currency would decline in response to a higher dom estic interest rate relative to the foreign interest rate. The Frenkel m odel m aintains that an increase in the relative expected inflation rate would lead to the depreciation of the zloty. The Frankel m odel com bines the assum ptions of the Dornbusch m odel and the Frenkel m odel. Note that the Dornbusch and Frankel m odels assum e that uncovered interest parity holds and that purchasing power parity holds in the long run. The expected exchange rate change is a function of the interest rate differential or is the deviation of the spot rate from its long-term rate plus the deviation of the actual inflation rate from the expected inflation rate. In other words, the long-term exchange rate is equal to the short-term exchange rate plus the real interest rate differential. The Balassa-Sam uelson effect can be tested by adding another variable to the first equation: e * * * - 0 + 1 ( M - M ) - 2 (Y - Y ) + 3 ( R - R ) + 4 ( N N ) + 5 (PT - PT ) + ( value of 95.754, the null hypothesis of no cointegration cannot be rejected at the 5% level. According to the Granger causality test, Granger cause each other, and Granger cause each other. or PTN Y -Y* * - PTN * and Y - Y and (2) where PTN is the log difference between the tradable sector price and non-tradable sector price in Poland and PTN - PTN * but not vice versa. M - M * Granger PTN * is the log difference between the tradable sector price and non-tradable sector price in the U.S. - Y * , e - e , or PTN - PTN * but not vice * * versa. R - R Y - Y but not vice versa. causes Y - - Y - Y * but not vice versa. 3. Empirical Results Monthly data were collected from International Financial Statistics, which is published by the International Monetary Fund. The sam ple ranges from 1992.M1 to 2005.M12 for the Dornbusch or Bilson m odel and from 1992.M6 to 2005. M12 for the Frenkel or Frankel m odel to account for lags in constructing the expected inflation rate. The data for the m oney supply beyond 2005.M12 had not been published at the tim e of writing. The exchange rate is expressed as zlotys per U.S. dollar.1 M2 m oney is used for the m oney supply and is expressed in m illions for Poland and billions for the U.S. Industrial production is selected to represent output as data for real GDP are not available on a m onthly basis.2 The m oney m arket rate in Poland and the federal funds rate in the U.S. are chosen to represent the interest rates. The average inflation rate of the past four m onths is used to represent the expected inflation rate.3 The tradable sector price is represented by the producer price index, and the non-tradable sector price is represented by the consum er price index.4 Except for the interest rates and expected inflation rates, all other variables are m easured in the logarithm ic scale. In the unit root test, the critical values are -3.468, -2.878, and -2.576 at the 1%, 5%, and 10% levels. All the variables have unit roots in levels and are stationary in first difference at the 5% level. According to the Johansen test, in equation (1), because the value of the trace statistic is estim ated to be 125.563 com pared with the critical value of 69.819, the null hypothesis that the exchange rate and other variables in equation (1) are not cointegrated cannot be rejected at the 5% level. In a sim ilar m anner, in equation (2), because the trace statistic of 159.091 is greater than the critical 1. The EUR/PLN exchange rate m ay be considered due to its increasing significance after joining the EU. However, the earliest data for the EUR/PLN exchange rate begin in 1999. The sam ple size m ay not be large enough to test m onetary m odels. 2. Ideally, real GDP instead of industrial production should be used in em pirical work. However, real GDP is reported on a quarterly basis, whereas industrial production is reported on a m onthly basis. If real GDP is used in em pirical work, the sam ple size will reduce by 75%, m aking the test of hypotheses m ore unreliable. 3. Consum er inflation expectations published by the NBP m ay be em ployed. However, num erical values were not readily available. Furtherm ore, the series ended in 2002.M12, which would reduce 36 observations in the sam ple. 4. The selection of the PPI and CPI to represent the price levels for the tradable and non-tradable goods m ay not reflect the changing com position of the service sector. R - R * e e but not vice versa. but not vice versa. PTN - PTN * Notes: Figures in the parenthesis are t-ratios. The critical values at the 1%, 2.5%, 5%, and 10% significance levels are 2.364, 1.984, 1.660, and 1.290, respectively. PTN is the log difference between the tradable sector price and non-tradable sector price in Poland. PTN * is the log difference between the tradable sector price and non-tradable sector price in the U.S. Table 1. Estimated Regressions of the Nominal Exchange Rate for Poland Table 1 presents estim ated regressions for different m odels and related statistics. The level form is em ployed in em pirical work because the use of first-difference m ay obscure the outcom e (Greene, 2003). The Newey-West (1987) m ethod is applied to yield consistent estim ates for the standard error and covariance when the form s of autocorrelation and heteroskedasticity are uncertain. In version (A), the positive coefficient of the relative m oney supply and the negative coefficient of the relative output are as expected and are significant at the 1% level. The positive and significant coefficient of the relative interest rate suggests that the behavior of the exchange rate in Poland can be characterized by the Bilson m odel better than the Dornbusch m odel. It im plies that an increase in the relative interest rate is expected to cause the zloty to depreciate. In version (B), the Frenkel m odel is tested. The coefficients of the relative m oney supply and the relative output have the expected signs and are significant. The positive and significant coefficient of the relative expected inflation rate indicates that an increase in the relative expected inflation rate would cause the zloty to depreciate. In version (C), the Frankel m odel is tested. The coefficients of the relative m oney supply and the relative output have the expected signs and are significant. The positive and significant coefficient of the relative interest rate is opposite to the assum ption of the Frankel m odel. The coefficient of the relative expected inflation rate is positive but insignificant. In every version the null hypothesis that 1 = 1 can be rejected at the 5% level. The root m ean squared error is used to determ ine which m odel would perform better in forecasting. The root m ean squared error is 0.229 in the Bilson m odel and 0.241 in the Frenkel m odel. The m ean absolute percent error is 5.673% in the Bilson m odel and 5.760% in the Frenkel m odel. Hence, the Bilson m odel has sm aller forecast errors than the Frenkel m odel. To m easure the effect of the productivity differential in the tradable and non-tradable sectors on the exchange rate, the Balassa-Sam uelson (1964) effect is tested. The coefficient of the relative price of the tradable to nontradable goods is positive and significant at the 1% level in the Bilson m odel in version (D) and in the Frenkel m odel in version (E) in Table 1. The Balassa-Sam uelson effect is not tested in the Frankel m odel because of an incorrect sign for the coefficient of the relative interest rate. The error correction m odel with a lag length of two is considered. In versions (B), (C), and (E), the coefficient of the error correction term is insignificant at the 10% level. In version (A), the coefficient of the error correction term is negative and significant, ( has a significant t -1 ) coefficient with a positive value, and all other coefficients are insignificant. In version (D), ( t -1 ) and ( t - 2 ) have significant coefficients, and all other coefficients are insignificant. To save space, details of the results are not printed here and will be available upon request. To account for a possible im pact of the adoption of a floating exchange rate policy since April 2000, a dum m y variable with a value of zero before April 2000 and one since April 2000 has been considered. The coefficient of the dum m y variable is positive but insignificant at the 10% level in the Dornbusch m odel, the Bilson m odel, the Frenkel m odel, and the Frankel m odels, and it is positive and significant at the 2.5% level in the regressions with the Balassa-Sam uelson effect. These results suggest that the pursuit of a floating exchange rate m ay lead to a depreciation of the zloty, holding other factors constant. Several different m easurem ents or versions are considered. Treasury bill rates in Poland and the U.S. m ay be considered to represent the relative interest rate. However, the data of the Treasury bill rate in Poland are not com plete. Real GDP m ay substitute industrial production in em pirical work. However, the sam ple size based on quarterly data will decrease 75%, causing hypothesis tests to becom e less reliable. Attem pts were m ade to include the relative stock price in the m odels without success due to the lack of com plete data for the stock price in Poland during the sam ple period. To save space, these results are not presented and will be available upon request. 4. Summary and Conclusions This paper has exam ined the exchange rate behavior for Poland based on four well-known m odels. Em pirical results show that the Bilson m odel and the Frenkel m odel characterize the behavior of the nom inal exchange rate for Poland better than the Dornbusch m odel and the Frankel m odel. The positive and significant coefficient of the relative interest rate in the Bilson m odel indicates that raising the dom estic interest rate relative to the foreign interest rate would cause the zloty/USD exchange rate to rise or the zloty to depreciate. The positive and significant coefficient of the relative expected inflation rate in the Frenkel m odel suggests that a higher expected dom estic inflation rate relative to the expected foreign inflation rate would cause the zloty to depreciate or the zloty/USD exchange rate to rise. The m onetary m odels can explain the behavior of the zloty/USD exchange rate reasonably well in view of a relatively high value of R2 and a relatively sm all value of the root m ean squared error or the m ean absolute percent error. There are several policy im plications. The Bank of Poland needs to m onitor its m oney supply. Increased m oney supply in Poland relative to the m oney supply in the U.S. would cause the zloty to depreciate. Contrary to what m any countries have been practicing, raising the dom estic interest rate relative to the U.S. interest rate would not help to appreciate the zloty against the U.S. dollar. A higher interest rate hurts consum ption and investm ent spending and would cause the zloty to depreciate even though it would cause international capital inflows and increase the dem and for the zloty. Maintaining price stability and a low inflation rate would help protect the value of the zloty. The positive and significant coefficient of the relative tradable to non-tradable prices m ay suggest that productivity differential is im portant in the determ ination of the nom inal exchange rate. There m ay be potential areas for future research. The m onetary m odels are based on the assum ptions of a stable m oney dem and function and the validity of purchasing power parity and uncovered interest parity. It m ay be interesting to study whether the m oney dem and functions for Poland and the U.S. would be stable. 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Journal

South East European Journal of Economics and Businessde Gruyter

Published: Nov 1, 2008

References