This is because of the nature of economic structure and policies. In addition to that, UK attracts large quantity of foreign investors due to its open economy. Thus, in policies regarding to monetary policies especially exchange rate determination should be good enough to sustain and attract other foreign investors. It is in this line of thought that this dissertation chapter shall empirically examine exchange rate determination in UK. In order to do that effectively, the paper look forward to validate the monetary model in the determination of the sterling pound exchange rate by applying cointegration methodology.
Introduction Exchange rate determination has a long history in the UK, this date back from Bretton wood era when exchange rate was fixed by agreement in relation to United States dollar from 1944 to 1971. However, after the United States government cancelled its undertaking to buy gold at a fixed rate the peg was abandoned. The new approach to exchange rate determination from 1971 was inevitable. United Kingdom and other countries were adopted a float to the currency, such that the price of sterling pound currency in terms of another currency was determined by foreign currency money market.
But today, the exchange rate determination regime is based on the exchange rates being adjusted at a regulated rate (Davidson, 1998; Dawson Baillie 2007; Fredrick 1968). Thus, the concern of this dissertation chapter on methodology is concerned about the validity of this regulation of exchange rate. Therefore, the objective of this paper is to empirically assess the relationship between sterling exchange rate with other major currencies and a vector of explanatory variables in the monetary model of exchange rates in order to establish whether the behavior of this exchange rate lends support to the monetary model.
This is an interesting area of study in relation to its importance to businessmen, academicians, investors and policy makers. In relation to the importance of the exchange rate determination, Rogoff and Maurice (1996), states that; issues relating to monetary approach to exchange rate is a core area and remains vital to bilateral trade involvement especial to Britain and other nations.
In regard to exchange rate determination aspect, the oversight of exchange rate history since 1970s (Richardson1979: 215), there has been a decline in the nominal value and fluctuations of the UK sterling pound in the world market against other currencies like US dollar and Japanese yen. This was as a result of the abandonment of the fixed exchange rates which were applicable across all transaction counters. But during the late 1990s the pound gained strengths due the available trade deficits with its trading partners.
In this connection, Laurence, (2005) states that monetary models of exchange rates are to help the economical conscious mind to establish whether there is a way by which exchange rates in the money market enhances support for the monetary models. Literature Review on methodology The monetary approach to exchange rates remains and continues to be a key area for spartial and temporary research in relation to field of international monetary and financial management. Due to this importance, the substantial contribution by xxxxemphasisis that exchange rate is a core area and remains key to bilateral trade involvement.
Thus, econometrics scholars emphasize on the proposition of monetary exchange unit as a prerequisite to bilateral trade rather than the transaction between the two trading partners (Davidson, 1998; Fredrick 1968). Exchange rate determination as a monetary exchange unit policy has bearing on the impact of trade and business transaction that may likely to occur between the UK and other trading partners. Therefore as a consequence, various studies have been done that constructs a rich body of knowledge that about the empirical examination of the monetary model in relation to the exchange rate determination in UK.
The monetary theory in regard to exchange rates suggests that the nominal exchange rate is determined by contemporaneous excess supplies of money between United Kingdom and the other trading nation. Nations that adopts and adhere to a relatively restrictive monetary policy usually experience an appreciation of their currencies against that of their trading partners, while the nations that adopt and adhere to a relatively expansionary monetary policy experience a depreciation of their currencies against that of their trading partners.
Therefore, theory application in practical aspect of econometrics in relation to exchange rate determination helps to project the proportional relationship between the relative money supply and the exchange rates between the bilateral trading nations for a specific period of time. The aspect of the theory that enables it to project the proportional relationship between the relative money supply and the exchange rates between trading partners of Britain, is important and has tangible and intangible implications at levels of policy, empirical and theoretical.
For instance, at theoretical level the monetary approach is the basis foundation for United Kingdom open economy. The theory of open economy was adopted from work of Lucas (1982) of open economy quantity theory. While at policy level, the theory has impact on the structural adjustment programs. These structural adjustment programmes are sponsored by IMF, World Bank and exchange rate misalignment in monetary unions that UK is a partner like EMU (European Monetary Union). Due to this domestic and global implication of the monetary model, it has not only been widely accepted, but also widely tested model for exchange rates in econometrics.
Rich body knowledge has been contributed by empirical Research conducted by other researchers like Wilford (1980); Haynes and Stone (1981); and Rogoff (1983), in their studies during the period of floating exchange rates to establish support for the model was not in favor of the model, since their evidence did not support the monetary model. While other category of researchers by Frankel, (1976); Billson, (1978); and Downburst, (1979). In their studies during the period of interwar and the periods of flexible exchange rates, the outcome of their results was largely supportive of the monetary mode.
In an attempt to explain the reason for poor performance of the model, Rogoff and Meese, (1983); hypothesized that the reasons for poor performance of the model was due to the constraints imposed on relative monies, assumptions of purchasing power parity, incomes, exogeneity of money supply, uncovered interest rate parity, interest rates, and the statistical problems were some of the hindrance that were pointed out. However the new approach to the model that incorporated the use and the development of the cointegration and error-correction statistical technique awakened the research into empirical examination of the monetary model.
Despite the renewed anxiety and drive for research to determine the validity of the model, there was mixed results coming from different researchers. For instance, research by Engle and Granger (1987); through employing a two-step cointegration methodology came up with negative response in support for a long-run relationship between exchange rates and the set of monetary variables as projected by standard monetary model. These results by Engle and Granger resulted to a low morale and discouragement for further research.
Hoper was found by the research that was conducted by Taylor and MacDonald in 1994, which they used multivariate method of Johansen and Juselius. The results of studies of Taylor and MacDonald supported that the model determine with precision the stylized facts of recent float because the residuals were I (0) (Gardner 2007; Huston 1969; Jonson 1999; James, 2008) and the point estimates are close to their a priori values. In regard to recent work on the model was that which was conducted in the year 1998 by Diamandis.
Diamandis employed relatively a more sophisticated approach to the study by using multivariate unit root test, cointegration test and panel unit root test that found a tangible support for the monetary model of exchange rates. Furthermore, Diamandis suggested that unrestricted monetary model is and should be a valid framework for explaining the long-run movements of exchange rates. To elaborate on the literature review, a lot has been covered by various scholars on the monetary model of the exchange rate in the UK and Europe at large.
Ranging from empirical studies during the flexible exchange rate periods, during the inter war periods (1970s) in Europe was done by Fredrick (1968) and Huston (1969). While the study and research on floating exchange rates during the post war period was done by Davidson, (1998) and Granger, (2002). Who found that there were constraints imposed (Taylor, Lucio 2003) on relative interest rates, monies and incomes, in addition to assumptions of interest rate and purchasing power parity and exogeneity of money supply within Europe and UK included that lead to the unworthy performance of monetary models in relation to exchange rates determination.
Up to the recent work by Diamandis that gave life to the monetary model through his supportive research outcome. The main reason for the high and intensity engagement in the research on the empirical test is all because the empirical monetary model of exchange rate is the most tested propositions in the countrys economic undertakings. Evidently, many scholars have had their take on the empirical determination of the exchange rate determination of which they have coming up with different and mixed empirical results.
This paper shall seek to empirically investigate the efficiency, effectiveness, validity and reliability of the monetary model for the bilateral exchange rate between the UK sterling pound and other currencies like US dollar. In order to do this examination effectively, the methodological approach is the use of the Gregory and Hansen (1996); cointegration test.