Macroeconomic Variables Affecting Exchange Rates for the US Dollar

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1. Introduction

Exchange rates are the price of a country’s currency in terms of another country’s currency. For example, the Japanese yen is pegged to the United States dollar which is known as the USD/JPY exchange rate. This in turn, means that exchange rates have two components, the domestic currency and a foreign currency, which can be quoted either directly or indirectly. A direct quotation is the price of a unit of foreign currency expressed in terms of a domestic currency, whereas, an indirect quotation is the price of 1 unit of domestic currency expressed in terms of a foreign currency. An exchange rate that does not possess the domestic currency as one of the two currency components is called a cross currency/cross rate which in
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Movement in the exchange rate has been said to be caused by changes in demand and supply of currencies which has been tested by (Rugman and Hodgetts, 2006) and Madura (2006). Volatility in exchange rate could be found by the help of different macroeconomic factors that affect supply and demand, thus when movement occurs in any given exchange rate, the new rate is determined at equilibrium, where supply and demand meet. Furthermore, Ray (2008) found that there is positive relationship between macroeconomic variables and the exchange rate where the relationship is positive when time factor is involved.

Aim of Study

This paper will aim to find which macroeconomic variables determine exchange rates relative to the United States dollar. The variables chosen have all been tested in previous literature against exchange rates, thus knowing that there may be some sort of link. The three currency pairs picked are the British pound, Japanese Yen and the Swiss Franc all relative to the United States dollar. Simple OLS least squares will be used to predict the three models and also the general-to-specific approach implemented. Yearly observations have been taken over a 31 year period for three currency pairs.

The paper will be split into five sections where the next section will consist of past literature towards the chosen the topic. The

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