Academic journal article Journal of Business Economics and Management

The Dollar/euro Exchange Rate and a Comparison of Major Models

Academic journal article Journal of Business Economics and Management

The Dollar/euro Exchange Rate and a Comparison of Major Models

Article excerpt

1. Introduction

The exchange rate of the U.S. dollar against the euro (USD/EUR) has fluctuated over time. It was 1.1608 in 1999.M1, declined to a low of 0.8552 in 2000.M10, and rose to 1.5552 in 2008.M6. During 2000. M10-2008. M6, the euro appreciated 81.9%. In recent months, partly due to the world financial crisis, movements in the USD/EUR exchange rate have caused some concerns. After reaching a high of 1.5923 on July 25, 2008, it continued to decline to a low of 1.2701 on November 28, 2008. The 20.3% depreciation of the euro against the U.S. dollar in less than four months suggests that it is appropriate to re-examine macroeconomic fundamentals of the behaviour of the USD/EUR exchange rate in order to determine whether different exchange rate models can explain recent depreciation of the euro against the U.S. dollar.

This paper re-examines the behaviour of the USD/EUR exchange rate based on the purchasing power parity (PPP) model, the uncovered interest parity (UIP) model, the monetary model, and the extended Mundell-Fleming model with several focuses. First, both the consumer price index (CPI) and the producer price index (PPI) are considered in the PPP model in order to determine which price index would be more appropriate (Taylor, A. M. and Taylor, M. P. 2004; Taylor 2006). Second, the generalized Box-Cox model (Greene 2003) is applied to test whether the widely used log-log functional form in the PPP model is appropriate. Third, in the monetary model, the Dornbusch (1976), Bilson (1978), Frenkel (1976), and Frankel (1979) versions are tested to determine which version works better. Fourth, in the extended Mundell-Fleming model, the financial stock value, the exchange rate, and the foreign interest rate are considered in the money demand function, and the interest parity condition is included in the simultaneous equations.

2. Literature survey

Several recent articles examine the dollar/euro exchange rate. Clostermann and Schnatz (2000) identify four fundamental factors affecting the real euro/dollar exchange rate. These are the relative real interest rate, the relative price, the relative fiscal position, and the real oil price. They find that a single-equation error correction model performs better than multivari ate models in the medium term. Galati and Ho (2003) show that the euro/dollar exchange rate exhibits an asymmetric response to macroeconomic news, seems to ignore good news and remain preoccupied with bad news from the euro zone, and is affected more strongly when switching from good to bad macroeconomic news. Salvatore (2005) indicates that the euro/dollar exchange rate is hard to predict mainly because it is very difficult to precisely model news and unexpected events and because models are unable to take into consideration all the fundamentals at work.

Haushofer et al. (2005) examine fundamental and nonfundamental factors of the euro/dollar exchange rate during 2002-2003. They find that increasing trade deficits and a weak job market contributed to the strengthening of the euro and weakening of the U.S. dollar, that fears of terrorism and war and accounting scandals in the U.S. strained the U.S. dollar, and that foreign exchange trading agents followed buy and sell recommendations to make the euro stronger. Altavilla (2008) studies relationship between the euro/dollar exchange rate and the fundamentals based on a nonlinear modelling. He finds that the relationship is unstable and that when the euro/dollar exchange rate is near its equilibrium value, it would be less sensitive to any shock in the underlying fundamentals.

Sosvilla-Rivero and Garcia (2005) use the PPP model with the inflation expectations differential derived from government indexed bonds to forecast the dollar/euro exchange rate and reveal that the forecast performance is better than the random walk model for up to 5 days. Schnatz (2007) shows that euro exchange rates exhibit nonlinear patterns and that market forces will bring the euro exchange rates back towards the PPP equilibrium from any deviation. …

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