Academic journal article The Journal of Developing Areas

Augmented Quantity Theory of Money and Bangladesh Taka - U.S. Dollar Exchange Rate Dynamics

Academic journal article The Journal of Developing Areas

Augmented Quantity Theory of Money and Bangladesh Taka - U.S. Dollar Exchange Rate Dynamics

Article excerpt

ABSTRACT

This paper studies the dynamics of the Taka-U.S.Dollar exchange rate for Bangladesh by augmenting the Quantity Theory of Money. The standard cointegration methodology (Engle and Granger, 1987) is employed in addition to the ARDL (Autoregressive Distributed Lag) procedure. The ADF and KPSS tests reveal data nonstationarity, but with different orders of integration. As a result, the ARDL procedure is invoked following (Peseran et al., 2001) to search for cointegrating relationship among the variables. On the evidence of cointegration, the vector error- correction model (VECM) is estimated. The negative sign of the coefficient of the error-correction term and its statistical significance in terms of the associated t -value confirm unidirectional causal flow from broad money supply and real GDP to Taka-U.S.Dollar exchange rate and long-run convergence with short-run interactive feedback effects. Furthermore, impulse response analyses are performed for additional visual insights.

JEL Classifications: E0, F3, F4

Keywords: Exchange Rate, Quantity Theory of Money, Cointegration.

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

Bangladesh pursued relatively restricted trade and exchange rate policies to deal with the immediate post-independence depressing economic conditions during 1971-1975. Since 1976, a series of trade liberalizing policies and exchange rate measures have been introduced to gradually transform Bangladesh into a small open economy. This is evident in the enhancing trade openness [(exports + imports)/GDP X 100] that rose gradually from 2.03 percent in 1976 to 31.49 percent in 2004. In addition to the current account convertibility, Bangladesh also switched to the floating exchange rate system in May, 2003.

Bangladesh has been experiencing persistent trade deficit (Appendix -2) unleashing unfavorable balance of payment pressures. The trade deficit in absolute amount was much higher, although the import to export ratio declined to 1.5834 in 2004 from 2.6482 in 1976 amid some fluctuations. As percentage of GDP, it is currently around 4.5 percent which does not yet pose a serious concern. Foreign aid dependency of Bangladesh has increased from 2.7945 to 3.0330 over the same period while debt service burden has declined from 14.6 percent of annual export earnings to 7.2 percent. As foreign aid inflows from the traditional sources are dwindling, Bangladesh has been striving to propel the economy through promotion of exports of goods and manpower to various destination countries. The concomitant remittances of emigration recorded spectacular increases as percentage of total exports from 2.7017 to 58.2710 over 1976 -2004. As percentage of total imports, it also rose from 1.0202 to 38.8006 over the same period. In other words, the remittances made by the Bangladeshi expatriates in 2004 were enough to finance over 38 percent of the total import bill.

Bangladesh has also made remarkable progress in exporting readymade garments and apparels that now top the export list of Bangladesh. In the subsequent years, the uptrend in remittance continued reaching around U.S. $ 5 billion in 2006. No discernible progress has been made, however, in enticing foreign direct investment due to perennial political instability and other unfavorable socio-economic circumstances despite granting a string of fiscal and financial incentives. The success in this regard has been dismal as compared to neighboring India and China. Tiny and underdeveloped capital markets are also unable to draw attention of the foreign portfolio investors. As Bangladesh emerges as a small open economy, exchange rate changes have profound implications for Bangladesh and exchange rate determination has become critically important.

The primary objective of this paper is to study the role of money supply and real GDP within the framework of much celebrated Quantity Theory of Money under some restrictive assumptions. …

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