Exchange Rate Regime - Korea - Essay Example

Exchange rate regime - Korea Summary of historical exchange rate regime in Korea The concept of real exchange rate regime can be attributed to the method which is employed by the government of different countries for the purpose of administering the currencies of their respective countries with respect to the major currencies of the world (Johnston & Swinburne, 1999, p.45). Exchange rate regime has always been vehemently linked with monetary policies and it may be stated that both the processes are highly dependent on a lot of similar factors (Exchange Rate Regime - Fixed and Floating exchange rate regimes, 2010). Now we will be discussing the history regarding the histories of Korean exchange rate regime. On May 3, 1964, there was abolition of the official rate of Korean currency whose official rate was Won (W) 130.00 per U.S. dollar with an establishment of a unitary floating system was established on a basic rate of around W 255.00 per US dollar. There was also introduction of foreign exchange certificates that were issued by the Bank of Korea against foreign currencies that could be sold in a free market. In November 1964, there was extension in the foreign exchange certificate system for covering practically foreign exchange dealings. With the establishment of fluctuating certificate rate system in the year 1971, there has been dynamic depreciation in the Korean currency. With the devaluation in US dollar there has been reduction in the gold content of Korean currency by a percentage of 7.89%. In the month of February, the currency of Korea established link with the U.S. dollar was being controlled and there was establishment of a floating exchange rate regime ( a regime where the exchange rate is freely determined by the foreign exchange market). Running a single currency peg against the US dollar there was introduction of multiple currency basket peg in Korea in 1980.The effective rate was associated with SDR (special drawing rights) along with the combination with basket of the currencies of the major trading partners of South Korea and they are namely USA, Japan, Germany and Canada. From the year 1989, the exchange rate of Korea was being allowed to fluctuate within a percentage range against the basic rate. In the month of March 1990, there was replacement of effective rate by a market average rate (MAR). There was a managed floating exchange rate regime with determination of market forces in the interbank market and the Seoul Foreign Exchange Market. Under the system of MAR, there were fluctuations in currency of Korea being restricted within a narrow band. There have been fluctuations within the exchange rate in the interbank market being the range widened from a rate of 0.4% to 2.25% in the time span of 1990-1995. With the decision of Thailand for the purpose of floating the currency of Thailand that is Thai Baht on the month of July 1997 with rapid depreciation in the Korean Won. For the purpose of defending the local currency, the government of Korea broadened the trading of its currency from a range of 2.25% to 10% with final abolishment of the band for the purpose of allowing the Won for floating on December 12. In the year 1997, the exchange rate of Korean currency was being allowed towards a floating exchange rate that has been determined through the interaction of demand and supply (Historical Exchange Rate Regime of Asian Countries, 2013). Thus it can be stated that the Korean currency has been subjected to quite a significant variation and has been volatile. 2. Three relationships (CIP, PPP, IFE) that describe the behavior of exchange rate 1. PPP and the behavior of exchange rate The purchasing power parity (PPP) is basically a theory which directs whether the exchange rates among various countries are in equilibrium at time when the countries have the same purchasing power (Shenkar & Luo, 2008, p. 237). This signifies that the exchange rate between any two countries will be equal to the ratio of the price level of the countries with respect to a fixed basket of goods and services. In case where the domestic price level increases there must be depreciation of the country’s exchange rate in order to return back to the purchasing power parity (PPP). PPP depends on the notion of one price law (Reinert et al, 2010, p. 942). When there is zero transportation and other transaction costs there will be equalization of price with respect to an identical good in two countries when the price are expresses with respect to the same currency. As for instance, if a particular commodity is sold for 750 Yen in China will cost US $ 500 in USA at the time when the exchange rate between China and USA is 1.50Yen/US$. Now, if the price would be only 700 Yen, the consumers in USA would prefer buying the product in China. With continuation of arbitrage process the US consumers who will be purchasing Chinese goods will be bidding up the value of Chinese Yen with the making of Canadian goods more costly to them. This process will be continuing until the goods have again the same price. The transportation costs, trade barriers as well as other transaction costs are deemed to be very significant. There will also be competitive markets for the goods and services in both the countries. The one price law will be applicable only to the tradable goods along with immobile goods like houses and many other local services between countries (Purchasing Power Parity, 2013). 2. CIP and the behavior of exchange rate Covered interest rate parity states that the returns from investment in the home currency must be equated with the guaranteed returns from investing in the foreign economy. It takes place in the forward exchange market which guarantees a specific return within the domestic currency with the guarantee of the return in their own currency through the selling of the yield in advance to a forward exchange dealer at the forward exchange rate. If the returns on the foreign assets surpass the proceeds from the domestic assets then the funds would be flowing into the foreign assets as well as the forward sales of foreign currency would be increasing the foreign demand for the domestic currency which results in the forward exchange rate in appreciating and the yield on the foreign assets to fall within the terms of domestic currency (Held, 1999, p.217). 3. IFE and the behavior of exchange rate The International Fisher Effect (IFE) is basically an amalgamation of the conditions of the theory of PPP and that of Fisher’s closed proposition. IFE directs that the interest rate differential will be equal to the inflation rate differential (Sharan, 2008, p.264).The International Fisher Effect (IFE) states that the rate of appreciation as well as rate of depreciation of currencies is associated to the differences in the nominal interest rate of interest. If there is holding of one price law which is depicted in the PPP for real rates of return then by the Fisher Effect, the nominal rate differentials will be highlighting the differences in the rate of inflation. From the amalgamation of the Fisher effect and the theory of PPP generates the international Fisher Effect (McDonald, Burton & Dowling, 2002, p.111). 3. Presentation of data- estimation of PPP between Korea and USA The principle of purchasing power parity (PPP) directs that over a long stretch of period the rate of exchange will be tending to offset the differences in the inflation rate between two countries which comprises of the exchange rate (Simonof, 2011, p.1). It might be also expected that within an inefficient economy, exchange rates would be giving each of the currencies of the country the same purchasing power within its own economy. Even if the notion does not hold in an exact manner the PPP model provides an accurate platform which directs the level of exchange rate that must be attained. A regression model can be best used to capture the situation. The model will go like this as follows: (Average annual change in the exchange rate)= α+ β*(Difference in average annual inflation rates) + a stochastic term (random error) The model that will be used here can be written as follows: Y= α+ β*X+ ξ…………………… (1) In the above equation, Y= E (t-1)-E(t)/E(t) and X=(P-P*), where E(t-1) is the exchange rate in the preceding month and E(t) is the exchange rate in the current month. The data collected and incorporated into the regression analysis includes exchange rate of Korea to USA from 2003 to the year 2011 taken on a monthly basis along with the CPI of Korea given by the symbol P and CPI of USA given as P*. After regressing it was found that the estimated regression equation which is as follows: Y= -0.000862034+ 0.00117587X …… (2) The regression result is given as follows: Regression Statistics Multiple R 0.059805745 R Square 0.003576727 Adjusted R Square -0.006004266 Standard Error 0.028937317 Observations 106 Table 1. Regression statistics From the above table it can be stated that the regression statistic R square do not show strong validity of the model. The value R square is 0.00358 (approx) which states that the independent variable X is not imparting significant effect on the dependant variable that is Y. The adjusted R Square also shows a weak value attached with a negative sign which shows that there is a negative relationship between Y and X. From equation (2), the value of intercept that is ‘a’ (intercept) is equal to -0.000862034 which signifies that the Korean currency has devalued by a percentage of 0.000862034.   Coefficients Standard Error t Stat P-value Intercept -0.000862034 0.003112625 -0.276947636 0.78237 0.90538 0.00117587 0.001924517 0.610994982 0.542536 Table 2. Main statistics The value of ‘b’ (slope coefficient) is 0.00117587 which signifies that the difference in X i.e. the difference between price levels is attached with an estimated expected 0.00117587 percentage point change in the exchange rates. In the above discussion of the regression coefficients there is an application of one unit increase in the inflation difference rate is associated with some percentage change in the exchange rates. In the process of describing the interpretations of the estimates with the actual unit terms of the associated variables whether it is in the percentage points or that of the currency. The t-stat provided in the output helps in testing the null hypothesis of b=0 is rejected in this case. The theory of PPP states that a=0. In this case the theory of PPP states that the value of a=0. In this case the t-state is -0.276947636 which shows a statistically insignificant result. This states that the foreign currency have appreciated more than as predicted by PPP. References Exchange Rate Regime - Fixed and Floating exchange rate regimes, (2010). Available at < http://www.economywatch.com/exchange-rate/regime.html> accessed on February 21, 2013 Historical Exchange Rate Regime of Asian Countries, (2013). Available at < http://intl.econ.cuhk.edu.hk/exchange_rate_regime/index.php?cid=7> accessed on February 21, 2013 Held, D, (1999), Global Transformations: Politics, Economics and Culture, Stanford University Press Johnston, R, B & Swinburne, M, (1999), Exchange Rate Arrangements and Currency Convertibility: Developments and Issues, International Monetary Fund McDonald, F, Burton, F & Dowling, P, Internationl Busns (2002), Cengage Learning EMEA Purchasing Power Parity, (2013). Available at < http://fx.sauder.ubc.ca/PPP.html> accessed on February 21, 2013 Reinert et al, (2010), The Princeton Encyclopedia of the World Economy. (Two volume set), Princeton University Press Simonof, J, S, (2011), Purchasing power parity: is it true?. Available at < http://people.stern.nyu.edu/jsimonof/classes/2301/pdf/ppp.pdf> accessed on February 21, 2013 Sharan, V, (2008), International Business 2/e , Concepts, Environment And Strategy, Pearson Education India Shenkar, O & Luo, Y, (2008), International Business, John Wiley & Sons Read More