Exchange Rate Fluctuations

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Applied Econometrics and International Development.

AEID.Vol. 6-1 (2006)

DETERMINANTS OF EXCHANGE RATE FLUCTUATIONS FOR
VENEZUELA: APPLICATION OF AN EXTENDED
MUNDELL-FLEMING MODEL
HSING, Yu*
Abstract
Applying and extending the Mundell-Fleming model, this study attempts to examine the behavior of short-term real exchange rates for Venezuela. It finds that the real effective exchange rate is positively associated with real government deficit spending and negatively influenced by real M2, the world interest rate, county risk, and the expected inflation rate. Hence, the authoritie s need to exercise fiscal discipline so that deficit spending would not be too large to cause real appreciation and hurt exports. When country risk rises due to the financial, economic or political factors, real exchange rates would depreciate.

JEL Classification: F31, F41, O54
Key words: Real Effective Exchange Rate, Country Risk, World Interest Rate, Monetary Policy, Fiscal Policy
1. Introduction
The Venezuelan government adopted different exchange rate regimes over the last several decades. During 1973.M2 – 1984.M1, the exchange rate was pegged at 4.29 or 4.30 bolivars per U.S. dollar. During 1984.M2 – 1986.M11, it was fixed at 7.50, and between 1986.M12 and 1989.M2 it was pegged to the dollar at 14.50. During 1983-1988, the monetary authorities adopted a complicated four-tier exchange rate regime that offered subsidized exchange rates to selected priority activities. By 1989.M3, the authorities pursued a floating exchange rate system based on the supply of and demand for the bolivar.

As a result, the exchange rate settled at 36.89 in 1989.M3. Large devaluations occurred in 1994.M5, 1996.M4, 2002.M2, 2002.M6, and 2003.M2 due to the decline in crude oil prices, inflation, budget deficits, political events, capital outflows, financial crises, or other developments. The IMF provided an assistance package in April 1996 and required Venezuela to raise taxes and public service rates, devalue the bolivar, increase the interest rate, and incur more debt but did not address fundamental structural reforms (Sucre, 1998). In July 1996, the authorities attempted to stabilize the exchange rate by allowing a band of 7.5% deviation from the central parity on either direction. The authorities would sell the U.S. dollar when the bolivar was weak and buy the U.S. dollar and the bolivar was strong (Gruben and Kiser, 2002; Gruben and Darley, 2004). In February 2002, due to substantial losses of foreign exchange reserves, declining oil prices, deteriorating government fiscal position, and very high interest rates, the authorities announced to *

Yu Hsing is Professor of Economics and head of the Department of General Business in the College of Business and Technology at Southeaster Louisiana University, USA, Editor of the International Journal of Applied Economics and one of the contributors of the Study Guide for the Principles of Economics by Professor N. Gregory Mankiw, e-mail: yhsing@selu.edu. 139

Applied Econometrics and International Development.

AEID.Vol. 6-1 (2006)

adopt a free floating exchange rate and gave up the controlled band of allowing up to 10% depreciation per year (Lifsher, 2002). Since early 2003, the authorities have periodically fixed the Bolivar/USD exchange rate at 1,598 in 2003.M2, 1,918 in 2004.M2, and 2,147 in 2005.M4.

This paper applies and extends the Mundell-Fleming model (Mundell, 1968, 2001; Huh, 1999; Obstfeld, 2001; Romer, 2001; Schroder and Dornau, 2002; Mankiw, 2003) to examine the relationship between the real effective exchange rate for Venezuela and several major macroeconomic variables. It is significant to study the behavior of the exchange rate for Venezuela. The bolivar has fluctuated and depreciated a great deal over the years. Understanding why exchange rates have depreciated considerably would help the authorities in their efforts to stabilize the exchange rate. Some of the previous studies...
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