Essays on exchange rate determination : an analysis of industrialised and emerging markets

The main contribution of this thesis is to assess the importance of economic fundamentals in affecting the nominal exchange rate behaviour for a sample of industrialised and emerging market economies. Industrialised and emerging markets differ in terms of economic stability conditions that may affect distinctly he performance of traditional exchange rate models. The thesis consists of investigating the effects of three interrelated determinants on the exchange rate variability which are examined from the early 1980s until the early 2000s: the effect of monetary fundamentals, the effect of rational speculative bubbles and the effect of foreign debt.

Firstly, we test the monetary model for both types of market economies by making use of panel techniques that allow for a high degree of heterogeneity across countries. We find partial support for the monetary model for industrialised market economies but not for emerging ones. This constitutes a puzzle as we would expect countries with greater monetary instability to show a stronger association between exchange rates and monetary fundamentals. Secondly, we test for the presence of a rational speculative bubble driving the stochastic process of exchange rates away from the equilibrium level defined by monetary fundamentals. Our findings reveal that the hypothesis of periodically collapsing bubbles driving the exchange rate away from the fundamentals solution cannot be accepted for a sample of four industrialised market economy countries. Moreover, the results also revealed significant non-linearities and different regimes. The importance of these findings suggests that linear monetary models may not be appropriate to examine exchange rate movements. Finally, we investigate the effects of foreign debts on nominal exchange rate volatility for a sample of industrialised and emerging market economies where the level of foreign indebtedness and the access to international credit markets differ substantially. We also test for the use of monetary policy and international reserves to stabilise potential exchange rate volatility. Our findings confirm that foreign debts do generate effects on exchange rate volatility in both types of market economies, with more significant impacts on financially fragile economies (emerging markets). The results also revealed that monetary authority interventions in the foreign exchange market are a common practice in both categories of economies. The importance of these findings commends government authorities to keep foreign debt at levels consistent with macroeconomic stability.