Competitive currency devaluations, quantitative easing and volatility of exchange rates

Document Type

Article

Publication Date

2004

Department

Accounting and Finance

Abstract

The pervasive quantitative easing, interest reductions and expansionary economic stimuli put into effect by advanced nations blunted the Great Recession (2007-9) and reverted the global economy decline. Foreign capital inflow to emerging markets was one of the major drivers for strong performance of equity and currency markets of emerging economies during the latter part of the Great Recession. It is observed that with advanced economies providing powerful monetary stimulus to revive their sluggish economies and emerging market economies (EMEs) facing a plethora of capital inflows amid strong recoveries, policy tensions arose between these two groups of economies. The reversal of capital inflow augmented by capital flights seems to have disrupted the equity and the currency markets of these emerging nations. This study argued that the tenuous parity relationships of exchange rates determinations that are entertained during normal economic conditions should be further tested in this unfolding economic environment. The enhanced volatility of exchange rates triggered by differing economic performance and relatively different economic tools used by different nations should make the determination of equilibrium exchange rates much more difficult. The study confirmed that the changes in exchange rates were more volatile during the Great Recession in comparison to the pre- or post- recession periods for industrialized nations. It is also found that the exchange rates were more volatile for emerging nations. The study examined the effectiveness of coordinated efforts of the central banks' interventions in the foreign exchange markets. The panel database of nine (U.S. as reference country) advanced industrial nations and nine emerging nations was used to test the significance of three two-way interaction terms; that is, multiplicative terms of the dichotomous variable (1 for the in-recession period and 0 for the pre- and the post-recession periods) and three monetary policy variables (money supplies, foreign exchange reserves and interest rates) The study found that the three two-way interaction terms to be highly significant. This implies that the coordinated efforts of the central banks' interventions in the foreign exchange markets using these tools were highly effective during the recession period in comparison to the pre- and the post-recession periods. However, the evidence of the coordinated interventions during the recession period was not apparent when the model was tested using the panel data of the emerging nations.

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