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The Relationship between

Inflation and Real ExchangeRate: Comparative Studybetween ASIA, the EU and

North America

Noer Azam AchsaniArie Jayanthy F A Fauzi

Piter Abdullah


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AbstractThis paper will be devoted to analyze the relevance of inflation

with the exchange rates. The research will try to compare theresponse or sensitivity of inflation to the changes in real exchangerates in Asia and compare the result with those of the EU and NorthAmerica.

Using explorative statistical analysis and Granger-causalitytest, we found that there is a strong correlation between themovements of inflation with real exchange rate in most countries to

be analyzed. For Asia, there is a significant causal relationship,where the nominal and real exchange rates have a significant impacton the rate of inflation. On the other hand, in the Non-Asian regions,the causal relationship seems to be in the opposite direction. wefound that the response or sensitivity of inflation to the changes inexchange rates in Asia is higher in compare to those in the EU and

North America.


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Introduction

B asic macroeconomic indicators can be usedas an illustration of a country's economic

condition. One of the basic macroeconomicindicators is inflation. Inflation is the increasein the average price level of goods and servicesover time. Generally, the inflation rate is usedto measure the price stability in the economy.


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Inflation can be divided into two sides

demand side inflation

supply side inflation


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For open-economy countries

domestic factors (internal pressure)

overseas factors (external pressure)


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Floating exchange rates

Exchange rate fluctuations can have a strongimpact on the level of prices through the

aggregate demand (AD)

aggregate supply (AS)


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C ontd..

Rana (1983) showed that the changes inexchange rates do not affect the inflation rate inASEAN, except Thailand. On the other hand,Kamin and Klau (2003) empirically found therelationships between inflation and the realexchange rates in most countries of Asia andLatin America. Furthermore, they found that theeffect of exchange rates changes on inflation in

Latin America was significantly higher than thosein Asia and industrialized countries. The previousstudies so far show an inconclusive results.


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Literature Review

An exchange rate represents currentmarket price of a currency in terms of other.Exchange rate system has a vital role in

reducing the risk of fluctuation in exchangerateSeveral factors affect the increase/decresein demand and supply of crrency


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C ontd..

These factors include Inflation,interestrate, Political stability, current accountDeficit.(Daniel J.Ikenson,2010;David,2010)

PPP TheoryPurchasing power parity theory states thatnominal exchange rate between two currenciesand ratio of aggregate price levels between thetwo countries must be equal, in other words bothcurrencies have purchasing power in a foreigncountry (Taylor 2004).


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C ontd

PPP seems impossible most of the time,because inflation rate varies among thecountries due to political conditions,government concerns Etc.High inflation rate in any country causesdecline in value of currency and viceverse(Barro & Robert, 1997)


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C ontd

Uncovered Interest rate parity Theory

UIRP showed no proof of working after 1990s

A number of empirical studies have

recommended that inflation is more linkedto floating exchange rate.(Alogoskoufis &Smith, 1991)


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C ontd..

These result had been questioned byBurdekin and siklos(1999)


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D ata & Methodology

Secondary annual data from Asian, European & North America for the period of 1991 to 2005

Data is obtained from IFS, WES & B loomberg;C alculation process by SPSS, Minitab, Evies

Exploratory data analysis to check behavior of data; Granger C ausality test to explore direction of relationships between two variables; Panel data modelto see whether difference exists between Asia, Europe& North America


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Explorative D ata Analysis

Time-series plot of Real exchange rate & inflation

Showed correlation between inflation and realexchange rate, with exception from Malaysia

Different behavior of exchange rate, before andafter Asia Financial C risis


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Time Series Plot of Inflation and ExchangeRate in Asia


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D ata Panel Analysis (fixed Effect Model)

Asia RegionR 2 = 0.66

Inflation is influenced by real exchange rates & previous domesticinflation

Asian Financial crisishas impact only Asianinflation

Non-Asia Region

R 2

= 0.60Exchange rate has nosignificant effect oninflation.

C oefficient of determination (R 2 = 0.607)


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Conclusion

There is strong relationship between inflation andreal exchange rate in Asian counties, but no suchrelation exists in EU & North America.

Asian Financial crisis has local Impact in Asiancountries and has no global impact.


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Questions; if any?

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