The Volatility of the Dollar Yen Exchange Rate: Cause and Effect

INTRODUCTION Basically there are two well established theories that explain and determine exchange rates. First, purchasing power parity (PPP), which quantifies the inflation exchange rates relationship, in other words it attempts to explain that exchange rates adjust based on the respective inflation rates in the two different countries. There are two forms of PPP theory. The absolute form of PPP states that given that there are no international trade barriers, consumers will tend to shift their purchases for goods and services to the country where the price os lower as measured by common currency. For example, exchange rates will eventually adjust where a basket of goods will cost the same both in the U.S. and Japan using a common currency. If the price in Japan is higher for the same basket, it will increase the price in the U.S. and decrease the price in Japan. This means the price in both countries should be the same when measured in common currency. The second theory of exchange rate determination is the interest rate parity theory. This theory states that one cannot make a greater profit by taking advantage of an interest rate differential in two different countries. Because the currency of the higher interest rate will depreciate either in the forward market or appreciate in the spot market. Suppose for example the interest rate in the U.S. is eight percent and the interest rate in Japan is four percent. A Japanese investor will be tempted to invest in the U.S. for the higher return. The increased demand for the dollar will tend to appreciate the spot rate of the dollar. On the other hand, at the end of the investment horizon when the Japanese investor demands to convert the dollars to yen, this increased demand in the forward market will increase the value of the yen in the forward market. Because of these two reasons, the gain made by the Japanese investor from higher interest rate will be wiped out, because of the adjustment in exchange rates. The interest rate parity must hold based on the following equation 1 + [d.sub.1] = 1 + [f.sub.1] (forward rate/spot rate) where [d.sub.i] = domestic rate and [F.sub.i] = foreign rate. The exchange rate must be a direct quote, that is, it must be yen per dollar. It must be foreign currency per unit of domestic currency. Here the U.S. is considered domestic and Japan is considered foreign. PURPOSE AND METHODOLOGY The purpose of this study is to determine the cause and effect of the volatility of the dollar/yen exchange rate because of the volume of trade between the two nations. The exchange rate of the dollar/yen has a great deal of impact on trade between the two nations. Several variables were considered as independent variables and exchange rate was used as the dependent variable. The independent variables are U.S. interest rates, Japanese interest rates, U.S. export, U.S. import, current account balance, CPI in Japan and the CPI in the U.S. These variables have been chosen because historically they have been found to be the ones that impact the exchange rate. Stepwise regression was used to include those variables that have the greatest impact on the exchange rates. Data on these variables were used from 1996 to 2007. The CPI for 2000=100. LITERATURE REVIEW There are many models that attempt to prove the interest rate parity theory of exchange rates. The article by Atkeson and Kehoe attempts to demonstrate how several of the economic models which attempt to predict changes to the conditional means of two variables (marginal utility growth and inflation). It does not take into consideration the changes in the conditional variances of how movements in the interest rates are mostly reflected in excess bond returns. The presented data show how the models fail to account for the excess returns from interest rate differentials (Atkeson & Kehoe, 2007) because based on interest rate parity covered interest arbitrage is not possible. …