The Classical approach to the Exchange Rate

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Theoretical Framework

There are a number of economic theories and study papers have tried to explain the rela-tionship between the exchange rate and commodity prices. The oil export countries’ ex-change rates may not directly be affected by the oil price, but indirectly be affected by the number of other facts which relates to the oil price, for example: trading balance, current account and foreign exchange reserves. These facts may affect the real exchange rate and nominal exchange rate in the long run (Green & Arnason, 1997).
In addition, the rising oil price leads the domestic wealth increases, especially in the oil ex-porter sector, this affect to increase the aggregate consumption with the general price in-creases. The incentive increased price may lead the supply of non-tradable goods and ser-vices increase whereas the imported goods and services prices decrease in the long term. So when the oil price increases, the nominal exchange rate may appreciate which lead the real exchange rate appreciate in order to bring back to the trading balance equilibrium in the long run (Freebairn, 1990).

The Classical approach to the Exchange Rate

For a commodity export country, the increasing price of commodities would lead the trade balance surplus increases. In the case of Norway, the oil price increases in the long run leads increase the ratio of world price received from the export sectors compare to the world price paid from the import sectors. The increased trade surplus would lead the net demand for the Norwegian Krone increases from the foreign trading partners and domes-tic export sectors. The increased demand for the Norwegian Krone leads nominal ex-change rate appreciates as long as central banks allow their currencies freely floating in the exchange rates regime.
Appreciated Norwegian Krone would make the domestic oil price which is accounted in Norwegian Krone increases less than the oil price in other currencies. In other words, the domestic economy and consumers would be less affected by the sharply increased oil price than the oil import nations. In addition, since the wage prices and consumer prices are among the stickiest indicators in the economy, appreciated Norwegian Krone also would gain its purchasing power more for buying the foreign goods and services relative to its domestic goods and services. This may encourage domestic consumers to buying more foreign goods and services which would help to reduce the trade surplus.
Arguably, in the gold standard, the trading balance would shift back to its equilibrium more quickly than in today’s fiat currencies standard. Because in the fiat currency regime, the trade deficit countries may easily issue the government debts to the trade surplus countries in order to fill the gap of the deficits as long as the trading surplus countries are willing to buy those debts. This may postpone the problem of the global trading imbalance and let the trading deficit countries “constantly” increase their debts whereas the trading surplus countries accumulate more debts from them. This kind of “Beggar-thy-neighbour” policy4 has been used for decades since the Bretton Wood system broke down, and many of the historians and economists have argued the current global trading imbalance is not sustain-able for the long run and it would threat the whole global financial system and society by demonstrating that “trade war” was one of the main reason coursed World War Two (Fer-guson, 2001).
In the US dollar case, most of the central banks are “forced” to hold US Dollar as foreign exchange reserve. The part of the reason is that the most of the international transaction is counted in US dollar. For example: commodities trading, debts in the developing countries and so on. Thus, United States has the “absolute” power to issue its debts in order to fill the gap in their deficits

Internal Adjustment to the Exchange Rate

As mentioned above, when the oil price increases, the oil export country would increase their trading surplus as well as oil export sectors would increase their wealth and income in the long run. In the economic theory, the most of these increased wealth and income would spend or invest into the sectors of non-tradable good and services rather than the imported goods and services (Freebairn, 1990). In other words, the increased spending on the imported goods and services would reduce the trade surplus, but may not significantly offset all of the gains from the trade surplus due to the oil price increases in the short to median term. These facts would lead increasing demand for the non-tradable goods and services which would generate general price inflation in the domestic economy. So as long as the domestic non-tradable goods and services prices increase, the incentive increased price would let these non-tradable sectors increase their supply in order to meet the in-creased demand. The resulting induced the real output increases which let the currency gain its purchasing power or lose less purchasing power relatively to other currencies. It helps the real exchange rate gain in the long run.
In the Norwegian case, since the oil industry is highly regulated by the government section, the most profits from the exporting oil are controlled by the government. So the govern-ment has the main power to allocate these increased wealth and income for the nation. So far, the statistic shows that the government has been improved its healthcare, welfare and education system for its nation since the oil was discovered. These efforts have put Norway on one of highest ranking for high living standard of the nation in the world. Nerveless to say, the healthcare, welfare and education are all non-tradable services, these increased out-puts may not be accounted into the purchasing power parity ratio, for example: Big Mac index; because it is very difficult to compare the real value of the service jobs in different countries. For example: A bartender in Sweden would earn about 25000 Swedish Krona a month; compare with a bartender in China may only earn about 3000 Swedish Krona a month. The quality of the service may not be so different as well as the real output in the societies. Although the most economists general agree that a good social care system would help the economy growth in the long run, especially for having a good education system.

International Capital Flow & Speculation

In the floating exchange rates regime, the role of expectations and international capital flows are critical to the nominal exchange rates. Suppose we known that the oil price would increase substantially in the long term, the international capital would flow into the coun-tries which have the oil reserves. The foreigner investors and investment institutions may invest into the oil fields, countries’ infrastructures and oil companies’ shares in the oil rich countries. These cash flows would influence the nominal exchange rate in the short term and median term. The new investments in the countries may let the countries to accelerate increasing their real outputs which also lead the real exchange rate appreciation.
In addition as mentioned above, when the oil price increases, Norwegian economy may face higher general price inflation. This may put pressure on Norwegian central bank to raise its interest rate. The empirical data shows that when the commodities price boom, the major commodities export countries may have higher interest rates than the commodities import countries (See Table 1). The differential between the interest rates may encourage currency speculators to bet on the currencies exchange rates by using carry trade5. It may course the nominal exchange rates fluctuate in the currency exchange market.
For example: in the US dollar/Norwegian Krone case, assume that the exchange rate of USD/NOK may not appreciate or depreciate in next 3 months. A currency trader may use the carry trade by selling US Dollar and buying Norwegian Krone in the currency market. Because of the differential of the interest rates, the trader still can make the profits on daily rolling swap rate.
Some central bankers may argue that it is very “dangerous” for the central banks adopt dif-ferent monetary policies for setting their interest rates. A significant gap between the inter-est rates would let the currency speculators take the “carry trade” opportunity and move the exchange rate sharply in a very short term. One of the most famous events was George Soros broke Bank of England on September 16th 1992.
“Until mid-1992, the ERM appeared to be a success, as a disciplinary effect had reduced inflation throughout Europe under the leadership of German Bundesbank. The stability wouldn’t last, however, as international investors started worrying that the exchange rate values of several currencies within the ERM were inappropriate. Following German reunification in 1989, the nation’s government spending surged, forcing the Bundesbank to print more money. This led to higher inflation and left the German central bank with little choice but to increase interest rates. But the rate hike had additional repercussions—-because it placed upward pressure on the German Mark. This forced other central banks to raise their interest rates as well, so as to maintain the pegged currency exchange rates (a direct application of Irving Fisher’s interest rate parity theory). Realizing the United Kingdom’s weak economy and high unemployment rate would not permit the British government to maintain this policy for long, George Soros stepped into action.” (Lien, 2008)
Following the event British Pound devaluated almost 15% against the Deutche Mark and 25% against US Dollar in the next 5 weeks. The consequence was Bank of England was forced to leave ERM and never came back again.

Government Economic Policy on Exchange Rate

There are number of government economic policies may directly or indirectly influence the exchange rates. For example: monetary policy, government fiscal policy, foreign trading policy, government subsidies and taxation. In the Norwegian case, the sharply increased oil price has put pressure on the Norwegian Krone for appreciation.
In 1990, the government established Government Pension Fund Global as a fiscal policy tool to support the long term management of Norway’s oil export revenue. The govern-ment transfers the oil export revenue into the fund which allows the fund to invest the capital abroad in foreign currencies. This means that the sharply increase or decrease oil export revenue has less impact to the domestic economy. Furthermore, because of most of the oil export revenue is dominated in “foreign currencies” . It not only helps the govern-ment to curb the significant gain on its exchange rate when the oil price sharply increases; but also the oil export revenue may not affect to the domestic money supply so much when the government “isolates” it trading surplus income in foreign currencies.
The Figure 8 shows that Norwegian central bank has accumulated huge foreign reserve due to the increased export oil revenues. It gives the government advantage for buying and in-vesting “profitable” foreign assets in their long perspective view. However the government may also face difficulty to diversify the huge foreign reserve in order to reduce the “risk”.
For example: when a currency crisis happens, and the huge foreign reserve might be wiped out if the government hold the investment of “bonds” in the currency. As John Bowden Connally told Europeans “Dollar is our currency, but your problem.” 6 40 years ago. Today’s global trading imbalance had reached much more extreme level, the trading surplus coun-tries have been accumulating foreign exchange reserve for more than two decades, whereas the trading deficit countries (not only US, but also many other countries) have been deep-ening into debts for decades.
Base on my personal view on the on-going European debts crisis, the high level debts countries may also be able to say to the rest of European nations (mainly North European nation) that “it is my country’s own fiscal policy, but it might be your banking problem too.” This has turned into a very odd situation that when the creditor lend too much to the debtor, so that creditor may suffer unacceptable loss when the debtor goes bankrupt.

Empirical Data Analysis

In this section, Augmented Dickey-fuller test, Engle-Granger test and Error Correction Mechanism are employed for detecting the relationship between oil price in US Dollar and nominal exchange rate of USD/NOK in the long run and short run.

Data Description

Due to the limited flexibility of the Norwegian Krone exchange rate until 2001 as I men-tioned above, I use the monthly data time series from 2001 January until 2011 April as data sample in order to find the relationship between the variables in the floating exchange rates regime. The data of real oil price in US dollar is downloaded from World Bank monthly commodity price7 and nominal exchange rate of USD/NOK monthly data is from the Norwegian central bank8. In addition, all time series data is transformed into natural loga-rithms for calculating the continuously compounded growth rate in the time series.9

Data approach and method

Most of the economic and financial data are non-stationary time series data, so it can easily courses the regression model to be spurious10. Therefore, one unit root test is used for de-tecting the time series data stationary.
If both of the time series data are found in same order of integration, then cointegration tests (Engle-Granger test) can be adopted for examining the long term relationship be-tween the variables.
Furthermore, even the regression model is proved as cointegration in the long run. The model still can be disequilibrium in the short run; the Error Correction Mechanism (ECM) can be used for the final test in order to detect the discrepancy in the two variables in the short run.

Test for Stationarity of the Variables

The Augmented Dickey-fuller (ADF) test is adopted to find if the variables is moving in the same order of integration. Generally speaking, there are three different forms in the one unit root test: a random walk process without drift, a random walk process with drift and a random walk with drift around a stochastic trend (Gujarati 2004). Therefore, the test is being conducted for all of these three forms for finding stationarity in the levels and first differences. In addition, Schwarz Information Criterion (SIC) is used for detecting the se-rial correlation in the residuals from both of the variables (oil price and USD/NOK).

Test for Cointegration

Since the above test shows that both of the time series variables exhibit I(1) behavior, the following step is to find if there is cointegrated relationship between USD/NOK exchange rate and oil price. Engle-Granger test can be adopted for detecting the cointegration in the long run when the two time series are cointegrated in the same order.
There are two steps for the Engle-Granger test, the first step is to run the cointegrating re-gression identified in equation:
In the equation (1), is representing USD/NOK exchange rate; is present-ing oil price in US dollar term; is representing as residuals. As both the dependent varia-ble and independent variable are transformed into natural logarithmic (ln), the equation (1) can be interpreted as 1% increase in oil price is equal to a β% increase or decrease in the nominal exchange rate USD/NOK.

Error Correction Mechanism

Above tests are just proved that the nominal exchange rate of USD/NOK and oil price in US dollar are cointegrated, there are long term relationship between two of the variables in the regression model. But the regression can be disequilibrium in the short term due to the two variables move off the track in the long term regression model. Error Correction Mechanism (ECM) is to find the discrepancy in the two variables in the short term.
“The error correction mechanism (ECM) first used by Sargan and later popularized by Engle and Granger corrects for disequilibrium. An important theorem, known as the Granger representation theorem states that if the two variables Y and X are cointegrated, then the relationship between the two can be expressed as ECM.” (Gujarati, 2004)
By using the variables of USD/NOK and oil price in US Dollar to apply the model of ECM, the equation would be written as:
As the Table 6 shows regression model result, so we can re-write the equation (3) as:
As the test result shows, -0.065087of the discrepancy is the one-period lagged value of the error from the cointegrating regression model (2). The equation (4) indicates 1% increase in oil price would lead Norwegian Krone appreciate 0.178118% against US Dollar in the short run.

Conclusion and Discussion

In this paper, I investigated whether the oil price in US dollar and nominal exchange rate USD/NOK have a cointegrated relationship in the run long. According to the empirical data analysis model, the test result shows that when the oil price rise 1%, Norwegian Krone may appreciate 0.268% against US dollar in the nominal turn in the long run.11 And the fi-nal test (Engle-Granger test) also proved that there is a cointegrated relationship between the oil price and nominal exchange rate USD/NOK.
Moreover, the ECM test shows that short run changes in oil price have a negative impact on short run changes in USD/NOK; one can interpret 0.178118 as the short run marginal appreciation effect on Norwegian Krone. It indicates the oil price increases 1% in short run would course Norwegian Krone appreciate 0.178118% against US dollar. The speed adjustment ( is -0.065087, which indicates how fast Norwegian Krone can move back to long equilibrium when the two variables fall off the track in the short run.
This result may not necessary to revise the earlier study papers which demonstrated that there is no integration between Norwegian Krone exchange rate and oil price due to the differential in the time series and the data variable of the exchange rates. As I pointed out in the beginning, it is very hard to find a strong relationship between the exchange rates and the price of good which is accounted in another currency. In addition, because Norwe-gian Krone had a limited flexibility in the exchange rate until 2001, the earlier papers could face difficulties in finding the cointegrated relationship in an “artificial” exchange rate re-gime.
Furthermore, since the global financial crisis in 2008 and the on-going debt crisis in Europe by the time I am writing this thesis, many international investors and economists have claimed that it is very difficult to find a “sound currency” which can preserve its purchasing power in the long run in the developed countries. For example: the US public debt to GDP ratio is around 100%, plus the US government may keep its annual budget deficit between 1 trillion and 1.5 trillion US dollar for the next 5 to 10 years base on its own projection. The Japanese public debt is around 200% to its GDP ratio; due to the older population in-creases, so the debts level may not be able to reduce so much in the long run. UK’s the public debt to GDP is 83% and the government project it may increase its debt to GDP ra-tio until 2015. The facts and economic history have showed that higher debt levels may not sustainable for the long term economic growth. And most importantly that debts crisis of-ten triggers serious currency debasement.

Table of Contents
1 Introduction 
1.1 Purpose
1.2 Outline
2 Background & Some Historical Economic Data
3 Theoretical Framework 
3.1 The Classical approach to the Exchange Rate
3.2 Internal Adjustment to the Exchange Rate
3.3 International Capital Flow & Speculation
3.4 Government Economic Policy on Exchange Rate
4 Empirical Data Analysis
4.1 Data Description
4.2 Data approach and methodology
4.3 Test for Stationarity of the Variables
4.4 Test for Cointegration
4.5 Error Correction Mechanism
5 Conclusion and Discussion
6 References
The Relationship between Oil Price and US Dollar/ Norwegian Krone Nominal Exchange Rate

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