Exchange Rates "Overshooting": An Empirical Study of Bangladesh and India

Abstract

Exchange rates are difficult to forecast because the market is continually reacting to unexpected events or news. Even in the absence of any major news, exchange rates adjust through the day as foreign exchange dealers manage their inventories and respond to trades with others who may be better informed. The role of exchange rate changes in eliminating international trade imbalances suggests that we should expect countries with current trade surpluses to have an appreciating currency, whereas countries with trade deficits should have depreciating currencies. Such exchange rate changes would lead to changes in international relative prices that would work to eliminate the trade imbalance. This paper analyses the movement of the exchange rates of Bangladesh and India over the period 1973-98. From the log-linear model of exchange rate finds that Consumer Price Index for both the country is the main variable causing the exchange rate fluctuations during this period. Exports, Imports, Interest Rates and Forward Rates of these countries do result in the movement of the exchange rates.

Keywords: Exchange Rates, Overshooting, Jump variables, Sticky-price, Exchange rate disconnect puzzle, International trade.

Australian Academy of Accounting and Finance Review, vol 1, issue 1, July 2015, page 86-102