Exchange Rate Determination in Developing Economies

doi:10.4236/me.2012.35067

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Modern Economy, 2012, 3, 518-521

http://dx.doi.org/10.4236/me.2012.35067 Published Online September 2012 (http://www.SciRP.org/journal/me)

Exchange Rate Determination in Developing Economies

Oluremi Davies Ogun

Department of Economics, University of Ibadan, Ibadan, Nigeria

Email: [email protected], [email protected]

Received July 19, 2012; revised August 17, 2012; accepted August 25, 2012

ABSTRACT

This paper identifies the determinants of nominal exchange rate movements in less developed countries operating the

flexible exchange rate system. Factors peculiar to such countries which are believed to potently drive their nominal ex-

change rates are incorporated into the resulting model. In particular, the weather, parallel market exchange rate and its

associated premium as well as corrupt practices enter the model. While all four factors should play crucial roles in ex-

plaining short-run variations in the exchange rate, corrupt practices may still be at work in the long-run. However, those

more advanced developing countries that have succeeded in instituting a relatively more effective legal system stem-

ming the tide of corruption, and, also characterized by a near absence of parallel exchange rate market, may follow the

standard model of exchange rate in the literature.

Keywords: Purchasing Power Parity; Parallel Market Exchange Rate; Parallel Market Exchange Rate Premium;

Corruption

1. Introduction

Either on its own or in terms of its linkage with the real

exchange rate (RER), the nominal exchange rate repre-

sents a powerful economic policy tool as it influences

resource allocation, growth of international trade and struc-

tural change. For a market economy, it is about the most

important relative price influencing practically all other

prices. Thus, it deserves utmost attention especially, in

matters of determination.

The theoretical literature on the determination of nomi-

nal exchange rate recognizes the influence of international

trade and payments, speculation and hedging activities.

Due however to the peculiar circumstance of most de-

veloping countries (being mostly agrarian and with a lax

legal system for examples), some factors that enter into

their exchange rate determination processes may be dis-

tinct. The aim in this paper is to highlight such subtle

distinctions. Section 2 below provides a brief review of

the theoretical literature while Section 3 deals with the

rate determination model. Section 4 gives some conclud-

ing remarks.

2. Related Literature

Four approaches to nominal exchange rate determination

are prominent in the literature (see e.g. Isard [1], Mac-

Donald and Taylor [2], Taylor [3]). They are the tradi-

tional model, the monetary model, the portfolio balance

approach and the purchasing power parity model. The mod-

els are briefly discussed below only in the context of

flexible exchange rate system.

In the traditional model, forces of supply of, and de-

mand for foreign exchange play crucial roles in the de-

termination of the equilibrium rate which emerges at the

equality of the supply of and the demand for foreign ex-

change. Capital flows perform important function in main-

taining equilibrium in this model with an outflow moder-

ating current account surplus and an inflow easing (finance-

ing) current account deficit. In order to prevent excessive

changes in the exchange under this approach, attention is

usually paid to the determinants of the changes in the

current account which are, relative prices and income.

Accordingly, a situation of current account deficit which

tends to depreciate the exchange rate calls for concerted

effort at reducing both domestic price level and income

while raising interest rate. However, the seeming over-con-

cern with policy actions to induce capital flows to finance

disequilibrium carries with it the implication of a passive

assumption that the asset market simply follows the pol-

icy dictates of the deficit country. Quite clearly, independ-

ent actions from foreign bond holders could throw a mon-

key wrench in the works.

The monetary model is similar to the traditional model

in the sense of relying on market forces albeit in the money

market to determine the equilibrium exchange rate. Un-

der this setting, the exchange rate adjusts to accommo-

date any disequilibrating development in the money mar-

ket. For example, monetary expansion which could pro-

duce an excess supply of money would also cause price

O. D. OGUN 519

level to rise leading to exchange rate depreciation. How-

ever, the level of wealth also increases causing the pur-

chase of financial assets (including, foreign assets) to rise

which in turn generates an increase in the demand for

money. Ultimately, the excess supply of money would be

mopped up and the exchange rate returns to its original

level in the long-run (see e.g. Frenkel [4], Frenkel and

Mussa [5] and Machlup [6]). Thus, given flexible ex-

change rate system, any disequilibrium in the money

market is short-lived and the exchange rate only changes

temporarily to accommodate this development otherwise,

balance of payments deficit would result. Pressure for

such (self reversing) short-run movements in the exchange

rate could also come from changes in interest rate and

income. The only drawback to this approach is that it

assumes unrealistically that the domestic and foreign

financial assets are perfect substitutes; this may be a

source of persistent disequilibrium under the model.

The Portfolio Balance approach views the exchange

rate as resulting from a process of financial equilibrium

in the economy. Such financial equilibrium results from a

simultaneous equilibrium in the individual financial asset

markets, that is, when the amount of each asset desired to

be held is the amount that is actually held. Three of such

markets are considered crucial here, domestic money or

monetary base, domestic bonds and foreign bonds. Three

equilibrium prices emerge from the attainment of this

financial equilibrium: equilibrium price of each asset, the

equilibrium interest rate in the country and the equilib-

rium exchange rate. The exchange rate emerges from this

model because any portfolio switches between the do-

mestic assets and the foreign asset necessitates new de-

mand for foreign exchange (Appleyard et al. [7]). How-

ever, it has been noted that the approach disregards the

fundamentals of trade in its calculations (Ojo [8]) and,

this may be a source of inexplicable changes in the ex-

change rate.

The Purchasing Power Parity (PPP) doctrine seeks to

identify the true equilibrium rate that would ensure si-

multaneous attainment of current and capital account bal-

ances. It exists in two versions, an absolute version and a

relative version. In a general context, the PPP postulates

that the price of any given commodity remains the same

in all countries when measured in the same currency. It is

therefore sometimes referred to as the law of one price

(LOOP) under which arbitrage plays an important role in

effecting the price parity across geographical locations.

Notwithstanding the infraction to this law often engen-

dered by transportation and handling charges, it is gener-

ally believed that the law is plausible. Accordingly, the

absolute PPP stipulates that the absolute level of the ex-

change rate is that which causes traded goods and ser-

vices to have the same price in all countries when meas-

ured in the same currency. There is however very little

empirical support for the absolute PPP due to the rather

strong influence of transportation costs and trade barriers

at keeping prices from equalising across geographical

locations, and the effect of the differences in the compo-

sition and relative importance of various goods on each

country’s price level determination (Appleyard et al. [7],

Rogoff [9]). As a result, the relative PPP is often resorted

to for operational concept. Under this version, the equi-

librium rate equals an initial period (base year) exchange

rate multiplied by the ratio of the price indices of the

domestic and foreign countries. In this way, the relative

PPP only captures an implicit rate, the real exchange rate,

and it is thus not particularly useful in the analysis of the

movements in the explicit rate, the nominal exchange rate.

3. The Model

This model describes the determination of the nominal ex-

change rate in a developing country operating the flexible

exchange rate system. The nominal exchange rate (NER) is

the price of foreign currency in units of domestic cur-

rency. It is assumed to be determined in the same way as

the prices of commodities that is, by the forces of the

market albeit, in the foreign exchange market. Thus, there

is a demand component, a supply component and an equi-

librium segment.

Broadly, the demand for foreign exchange (D) is in-

fluenced by three factors: changes in the level of imports

(M), capital outflow in the form of transfer payments,

grants and loans, overseas investments (Co) and specula-

tion (Sp)1. Thus,





DDM,Co,Sp (1)

Changes in the level of imports would be a function of

changes in domestic price level (π), and income (Y). Capi-

tal outflow would be influenced by the quest for overseas

investment by governments and residents and this quest

would be a function of foreign income (Y*) and relative

inflation rates (π – π*) as well as capital flight. Capital

flight can be simply expressed as a function of interest

rate differential (i – i*) and socio-economic instability

that can be represented by fiscal deficit (FD) and corrupt-

tion (C) which in turn can be proxy by corruption per-

ception index. Under a dual exchange rate system, the

parallel market exchange rate premium (PMP) would

also qualify as a proxy for corruption. Speculation can be

narrowed to the existence of parallel market exchange

rate (PMR) or its premium (PMP), so that we write2,

2Since by assumption, the model relates to an economy operating the

flexible exchange rate system, speculative activities of the type of leads

and lags are minimal in the absence of any expected major currency

realignment policy as could happen under a fixed exchange rate system

and its variants.

1The influence of hedging in the domestic economy is in this model sub-

sumed under speculation.

O. D. OGUN

520



***

DDπ,Y,Y ,ππ,ii, FD,C, PMR, PMP (2)

with all partials expected to be positive.

On the other hand, the supply of foreign exchange (S)

will be a function of changes in exports (X), foreign in-

vestments (FI), changes in foreign reserves (R) as well

as speculation and hedging activities of foreigners (Sh)

such that we can write,



SX,Fi,R,Sh



(3)

Changes in export will be a reflection of the interna-

tional price of export items and weather condition

in the domestic economy which can be proxy by a trend

variable (TT) reflecting the difference between actual and

trend real agricultural output. Foreign investment would

be influenced by general reform climate which can sim-

ply be represented by the real exchange rate (RER). Chan-

ges in foreign reserves would be a result of changes in

the balances on both current and capital accounts which

are in turn influenced by price level changes, income, in-

ternational price of exports, weather conditions and inter-

est rate differentials. Speculation and hedging activities

of foreigners would be influenced by parallel market ex-

change rate (PMR), inflation differentials (π – π*), inter-

est rate differentials (i – i*) and the size of the stock

market represented by its market capitalization (MK).

Thus, we have that,





E**

SSπ,Y,P,TT,ππ,ii ,MK,RER,PMR (4)

Except for π – π* and PMR, all partials are expected to

be positive.

Incorporating income differential to track the effect of

long-run capital flows, equilibrium NER equation would

result from the net of Equations (2) and (4) such that,





**E

EEππ, Y,YY, P,TT,ii,

FD,C,MK, RER,PMR,PMP



 

(5)

Apart from inflation differential (π – π*), fiscal deficit

(FD), parallel market exchange rate (PMP) and the paral-

lel market exchange rate premium (PMP) whose changes

would produce a depreciating effect on the exchange rate,

all other variables’ partials are expected to be positive4.

Four variables, TT (trend variable capturing the influ-

ence of weather condition), C (corruption), PMR (paral-

lel market exchange rate) and PMP (parallel market ex-

change rate premium) appear to be peculiar to the typical

developing economy. Corruption exists in almost all coun-

tries of the world but the nature and manner of occur-

rence of the vice in developing countries are such that, it

generates serious adverse consequences for the growth of

such economies in the short-run (see e.g. Asiedu and

Freeman [11], Anorou and Braha [12]) and the long-run

too (see e.g. Dissou and Yakautsava [13] and Ogun [14]).

To escape detection and legal or political restitution of

the looted treasury funds, such funds often take on the na-

ture of capital flight. Thus, unlike in most advanced coun-

tries, such looted funds hardly contribute meaningfully to

economic activities in the typical developing country5.

Furthermore, in the course of their flight, the looted

funds often produce new distortions or reinforce existing

distortions especially, in relative prices, in the economy.

In most cases, the parallel exchange rate market is patron-

ized with the associated rate rising significantly, thereby,

putting upward pressure on the related parallel market

premium as the main market exchange rate (and the in-

ter-bank rate too) depreciates. It was reported in Ogun

[15] that the explosion in commodity prices witnessed in

the late 1980s (the early years of the switch from fixed to

flexible exchange rate system) in Nigeria was due to the

incidence of capital flight. The parallel market rate and

premium were also joint beneficiaries6.

3The marked difference in the definitions of the parallel market exchange

rate and the parallel market exchange rate premium, should reduce the

ossibility of multicollinearity from their joint presence in the equation.

The premium could for example be defined as the percentage excess of the

arallel market rate over the official rate (see e.g. Dornbusch et al. [10]).

4Foreign income does not enter the equilibrium equation independently

because the motives for its entry are already captured by interest rate

differentials and stock market capitalization. Where there is a compel-

ling urge to include foreign income in Equation (5) as part of the de-

mand drivers for export hence, source of supply of foreign exchange,

the nature of exported items (that is, whether they are luxuries or ne-

cessities to the importer country) should be considered instead.

5There are other forms of corrupt practices which though do not end up

in capital flight also exert appreciating influence on the exchange rate

through the related parallel market rate and premium. An example is

the well-known practice of round-tripping by banks under which they

bid for and purchase foreign exchange at the auction (autonomous mar-

ket’s) rate but end up selling at the parallel market at that market’s rate.

Government agencies are sometimes accomplices in this act as they spe-

cially arrange for sizable government funds to be placed on deposits

with these banks and thus increase the banks’ and the agencies’ profit

from such round-tripping business. Overall, the reduced supply inthe

conventional market raises the inter-bank rate and the autonomous mar-

ket’s rate both of which could put upward pressure on the official rate;

the bureaux de change and the parallel market rates similarly benefit from

the increase in the patronage of the related markets.

In general, while the effects of PMR, PMP and the

weather on nominal exchange rate should be expected to

wear off in the long-run7, that of corruption may still be

active in the same run8. However, some of the more ad-

vanced developing countries may be spared the influence

of these additional variables. Usually, such countries are

not capital (including, foreign exchange) scarce, hence,

the incentive for a thriving parallel exchange rate market

6Incidences of leads and lags hedging practice may have been contributory

to the emergent exchange rates but were in this particular instance, indis-

tinguishable from the broad play of capital flight.

7Prolonged adverse weather condition would usually elicit policy resp-

onse to mitigate its macroeconomic effects.

8Two variables in the standard model, inflation differential and income

or real income (or its growth)—the latter as a proxy for productivity

growth, could similarly exert long-run effect. Other long-run factors

though not written into the model include, taste (that is, preference for

domestic or foreign goods) and, tariffs and quotas. For further details

onthese additional long-run determinants, see for example, Mishkin [16].

O. D. OGUN

521

is almost non-existent. In addition, they have mostly suc-

ceeded in instituting a relatively effective legal system

helping to stem the tide of corrupt practices. Thus, such

economies are more likely to be accurately represented

by the standard exchange rate determination model in the

literature.

4. Conclusion

Existing models of nominal exchange rate determination

in the literature mostly ignores the peculiar developments

in developing countries and therefore inaccurately de-

scribes the modalities of short run movements in these

countries’ nominal exchange rate. This paper rectified this

oversight by developing a model which accommodates

those crucial but unconventional determinants of the nomi-

nal exchange rate in the typical developing economy. Fac-

tors such as weather condition, the existence of parallel

market exchange rate, its associated premium and corrupt

practices are identified to be critical drivers of short term

variations in the nominal exchange rate. Even, in the

long-run, a factor such as corruption could still be play-

ing very important roles. It should however be under-

stood that only particular types of developing countries’

exchange rate dynamics would be explained by this model.

Some advanced developing countries may have developed

a more effective legal system curtailing corrupt practices.

Such countries’ exchange rate system may also be devoid

of the sharp parallel market practices bestriding the less

advanced developing countries’ exchange rate system. In

this case, the standard modelling approach noted in the

introductory section would be more applicable.

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