What Drives Exchange Rates?: The Case of the Yen/dollar Rate

Abstract We investigate the pattern of dynamic interactions between the yen/dollar exchange rate and a set of fundamental macroeconomic variables during the post-Bretton Woods period. The major findings are: First, the proportion of exchange rate volatility attributable to the market fundamentals is quite small in the short run, e.g., 15.20% at a 3-month forecast horizon, but it increases steadily as the horizon gets longer, reaching 56.91% at a 24-month horizon and 61.98% at a 36-month horizon. Thus, the fundamentals matter in the long run. In the short-run, however, the exchange rate volatility seems largely self generating. Second, among the fundamentals, the interest rate differential and the relative money supply emerge as the most influential variables driving the exchange rate. INTRODUCTION Since the inception of the flexible exchange regime in the early 1970s, the exchange rate has been substantially more volatile than earlier pegged rate periods. As a result, the behavior of exchange rate has been investigated in many different contexts.' Among the recent investigations on the behavior of exchange rate, we may obtain the most important insights from the financial asset view of exchange rate posited by the asset market approach, e.g., Frenkel and Mussa (1980) and Mussa (1982). The basic idea of the asset market approach is that foreign exchange has common characteristics with other financial assets: An exchange rate is the relative price of two assets (i.e. currencies). The market efficiency postulated for financial assets is an implication of the financial asset view of the exchange rate. Specifically, the current spot exchange rate reflects all relevant information concerning present and expected courses of fundamental determinants of exchange rate. The financial asset view, therefore, implies that the exchange rate changes only in response to information (news or innovation) contained in unexpected change in fundamental variables relevant to the asset's price determination. Existing literature pays relatively little attention to the dynamic responses of exchange rates to unexpected changes in fundamental variables with the exception of Dornbusch (1976). Furthermore, exchange rate theories traditionally considered fundamental variables as exogenous to the exchange rate. Thus the possible multilateral interactions among fundamental variables and the exchange rate itself tend to be ignored in the literature. However, it is apparent that both the exchange rate and fundamental variables would be regarded as endogenous in a model allowing for multilateral interactions among themselves. The purpose of this paper is to examine the mechanism of dynamic multilateral interactions between the yen/dollar exchange rate and fundamental variables under the flexible exchange regime. Specifically, this paper addresses the following issue: How is the yen/dollar exchange volatility accounted for by each of fundamental variables, including the exchange rate itself? The empirical results may help to identify relevant fundamental variables which affect the volatility of the yen/dollar rate most. The primary reason for focusing on the yen/dollar exchange rate is the considerable fluctuation in the yen/dollar rate in recent years. The fluctuation affects all levels of economic activities and financial decisions not only for the U.S. and Japan, but also for other Asian countries and elsewhere. Traditionally, Asian countries tend to settle their international trade using either the U.S. dollar or the Japanese yen. The alignment of the value of their currencies when compared to the yen/dollar rate has always been an important policy issue for some Asian countries. Asian countries, therefore, closely monitor the behavior of the yen/dollar rate to decide a favorable currency to settle their international transactions. Furthermore, the U.S. and Japan are two leading economic powers in the world. …