Critically discuss the causes of nominal and real exchange rate fluctuations, misalignments and the exchange rate policy in Central and Eastern European countries.

Running head: NOMINAL AND REAL EXCHANGE FLUCTUATIONS 1

NOMINAL AND REAL EXCHANGE FLUCTUATIONS 2

Causes of nominal and real exchange rate fluctuations, misalignments and the exchange rate policy

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Fluctuations in Nominal Exchange Rate Comment by Microsoft: Can add introduction part: for example, “In 2008, both the international financial market and the global economy were turbulent due to the financial and economic crisis. This crisis has caused violent exchange rate fluctuations, and lead to an uneven effect on the currencies of major industrial countries. For example, the euro and the dollar move significantly and have experienced appreciation and depreciation. + situation in Turkey + real/nominal exchange rate why important (u did already) + my study is…”

The monetary approach is useful in explaining exchange rate fluctuations. Its predictions are specific, and in case of the relative money supply increases, so does the relative price level. The monetary approach is useful in explaining the exchange rate fluctuations since there is a better proportion of the movement that is relative to the money supply. There is unity in the elasticity of the spot rate. Such an agreement is based on the relative money supply.

Purchasing Power Parity Comment by Microsoft: Need to use PPP as a theory, and use inflation differential to explain perentage change of nominal exchange rate Ans use formula : NER = - * Otherwise, how u get D. inflation?

Purchasing power parity= P1/P2

The purchasing power parity for Turkey was 1.6 per international dollar marking an annual growth rate of 12.59%

Interest Parity Condition Comment by Microsoft: Same problem, need to mention Interest rate differentials, Inflation differentials, Monetary growth differentials, Trade balance by using the theory (Purchasing Power Parity, interest parity condition, money supply and trade balance). then Combine the theory and result, whether those variable above could be the reason that lead to percentage change in nominal exchange rate based on the monetary approach. Based on result, whether the monetary approach is useful in explaining exchange rate fluctuations. If not, what are the limitations Methodology part require theory +data analysis. Beginning use theory to explain , later on u should check whether the graph u get is consist with hypothesis that based on your theory. And answer the question whether relative productivity growth rates explain the movements in real exchange rate movements Is meaningless to put the graph without explanation. Moreover, could explain how u measure relative productivity of tradable goods, use GDP or employment for relative productivity or industrial production

(1+ Base currency)= Forward foreign exchange rate/Current spot exchange rate* (1+ quoted currency)

Interest parity condition= 1.32* (1+0.0117)/ (1+0.03029)

Interest parity condition= 1.296

Money supply

Money supply= 1/Reserve Ratio

Money supply = 1/0.116

Money supply= 8.62

Trade Balance

Trade balance= exports- imports

Trade balance = 55.13 billion U.S dollars Comment by Microsoft: There is no trade balance in the graph, if the value for trade balance is too high, and prevent to see more clearly the changes in other variables. Then could probably use two graphs to represent. For example, the first graph with all variables, the second one without trade balance

Year	D. interest rate	D. inflation	D. monetary growth	Percentage change in the nominal exchange rate
2008	9.84	2.203	3.24	0.0187
2009	6.13	4.567	(17.79)	-0.0941
2010	5.57	3.215	(3.06)	-0.0175
2011	6.93	0.773	(8.08)	-0.0094
2012	5.59	3.582	(10.62)	-0.0559
2013	2.91	0.268	1.85	-0.0078
2014	1.98	-1.849	11.04	-0.0277
2015	1.11	-0.180	14.08	-0.0357
2016	0.36	-0.866	12.17	0.0102
2017	-0.40	0.218	16.59	0.0155
2018	-1.37	0.407	15.96	-0.0122

Fluctuations of Real Exchange Rate Comment by Microsoft: You are expected to calculate real exchange rate growth rates (by using nominal exchange rates and price level (CPI, PPI, or GDP deflator) and observe whether relative productivity growth rates explain the movements in real exchange rate movements. Prepare a table showing the percentage changes in real exchange rates and relative productivity changes.

The Balassa-Samuelson model can be used in explaining the foreign exchange fluctuations. The assumptions of the model can be used in providing empirical evidence. The model helps in analyzing the real exchange rates that exist in the real factors. The model helps in explaining the significance of the real exchange fluctuations in the developing economies, especially in Turkey. The monetary equation of the Balassa-Samuelson model is used in describing the current group of the accession countries. The model can be used in defining the foreign exchange fluctuations since its effects can be incorporated into the monetary equation. One of the ways through which the equation can be included is through making assumptions that the overall prices in a country are a weighted average of the price (Fidrmuc, Cuaresma & MacDonald, 2004). The model can be used in analyzing any adjustments on the exchange rates. The results are effective since there is efficiency in the way they derive the free-floating regime during the sample period.

Exchange Rate Policy in Turkey

In 2009, the Central Bank of Turkey implemented the floating exchange rate regime. Such a system was along with the inflation targeting. The exchange rate had a significant implication towards the effectiveness of the foreign exchange markets through the determination of the supply and demand conditions (Mihaljek & Klau, 2008). The monetary and fiscal policies implemented were some of the critical issues that affected the foreign exchange markets. Other factors that impacted the foreign exchange markets included international developments, economic fundamentals, and expectations.

Since there was no need for maintaining the exchange rate level, there was a need for a robust foreign exchange reserve position. Such an exchange rate policy was critical for Turkey, especially being one of the emerging economies. The policy contributed towards the efficiency of the foreign exchange markets through its elimination of different unfavourable effects. The adverse effects that were being eliminated included the ones that would result in the internal and external shocks. The Central Bank of Turkey has the responsibility of holding the foreign exchange buying auctions. The Central Bank holds such auctions so that it can build up reserves until the periods when the foreign exchange supply raises concerning the foreign exchange demand.

The exchange rate policy contributes to the efficiency of the foreign exchange markets by reducing the impacts of the conditions of supply and demand in the foreign exchange market. The Turkish Central Bank continues to use the pre-announced terms and conditions to buy the foreign exchange through the transparent foreign exchange buying auctions. However, the principal aim of the Central Bank is to run any sale based on the pre-announced program (Fidrmuc, Cuaresma & MacDonald, 2004). However, different amendments to the auction programs can be developed before the notice is provided, especially when there are various unexpected developments on the foreign exchange supply.

In 2008, the foreign exchange rate policy indicated that the maximum amount of the foreign exchange that was going to be bought daily was USD 90 million. In the USD 90 million, USD 30 million was for the auction amount while the remaining USD 60 million was for the optional selling amount. Nevertheless, there was increased volatility in Turkey`s foreign exchange market. The volatility was in correlation with the level of stagnation that was expected from most of the developing economies. The Central Bank reduced the amount that was supposed to be purchased daily to USD 45 million as of 10 March 2008.

Since October 2008, the Central Bank implemented a variety of measures. The principal objective of implementing such measures was abating different potential problems under the Turkish financial markets. Such measures implemented by the Central Bank were supposed to lead to global developments. Because of such scope, there was a suspension of the foreign exchange market to keep the liquidity (Mihaljek & Klau, 2008). Such liquidity is taken off from the foreign exchange market permanently using the foreign exchange buying auctions. The suspension was as well undertaken to enhance the liquidity conditions of the Turkish banks.

In addition to the foreign market policy contributing to the efficiency of the foreign exchange markets through the suspension of the foreign exchange buying auctions, the efficiency was as well conducted through the injection of the foreign exchange liquidity into the market. The decrease in the depth of the foreign exchange market was witnessed as a result of the unhealthy price formations (Fidrmuc, Cuaresma & MacDonald, 2004). As part of maintaining the efficiency in the foreign exchange markets, the amounts of the unfamiliar that was supposed to be sold through the auction were reduced. However, such amounts were going to be increased if there was any necessity.

It was as well announced that based on the current developments in the foreign exchange market, there were changes in the daily auction amounts. During the same year, it was also announced that the auctions might be suspended if it was found necessary. The Central Bank proceeded with suspending the foreign exchange selling auctions (Mihaljek & Klau, 2008). The decision was made due to the easing concerns that concerned the depth of the foreign exchange market. That objective of suspending the auctions was mostly facilitated by the growing developments in the global markets.

During the duration, there was an increase in problems concerning the international credit market because of increased concerns about the credibility of the financial system. Therefore, the exchange rate policy was developed in a way that it could ensure there was efficiency in the foreign exchange market. Such measures were as well implemented to strengthen foreign exchange liquidity (Korteweg, 1982). Such actions would be useful in different incidences, especially when the banks were faced with liquidity problems.

On 2008, the Central Bank intended to focus more on mobilizing the foreign exchange liquidity in the Interbank Foreign Exchange Market. Such objective was supposed to be achieved through resuming its intermediary activities in the foreign exchange. Such events were mostly focussed on the Foreign Exchange and Banknotes Markets. As part of ensuring the foreign exchange market was efficient, the foreign deposits were borrowed within the predetermined borrowing limits. Such borrowings were based on the foreign exchange deposit markets (Fidrmuc, Cuaresma & MacDonald, 2004). The Central Bank dropped the deposits of the foreign exchange deposits from 11 per cent to 9 per cent. That reduction facilitated the banking system with additional liquidity of the foreign currency.

Based on the challenges that existed in such environments, it was important for Turkey to ensure there was efficiency when utilizing the foreign exchange reserves. Nevertheless, all those implementations were considered only when it was necessary. The Central Bank continued to take all such measures to ensure there was efficiency in the function of the foreign exchange markets (Mihaljek & Klau, 2008). That was part of ensuring there was appropriate support of the foreign exchange liquidity. There was a reduction in the lending rate in the Turkish markets.

In the event of intensifying the financial markets, the Turkish economy was negatively affected. Some of the challenges that the economy experienced included the unhealthy fluctuations that were suffered because of the reduction in the depth of the foreign exchange markets that were being held. Another challenge is that there was an increase in the limits of foreign exchange. There were as well limitations in the foreign exchange reserves that were required. The Central Bank continued to monitor the exchange rates, especially during 2009 (Fidrmuc, Cuaresma & MacDonald, 2004). The exchange rate policy ensured there was close intervention in the market whenever there were any unhealthy fluctuations, especially in the foreign exchange markets.

As part of ensuring that the exchange rate policy facilitated efficiency in the foreign exchange markets, it provided there was effectiveness in the recovery of different development in the international markets. The Central Bank resumed its strategy of buying the foreign exchange auctions. The objective of such an approach was to ensure that the foreign exchange reserves were strengthened. This took place mostly when the foreign exchange supply had increased compared to its demand (Korteweg, 1982). While the exchange rate policy is ensuring the foreign exchange markets are efficient, the policy needs to ensure that there are adequate risk management mechanisms.

How the Models Explain the Nominal and Real Exchange Rate Movements During Crisis and Post-Crisis Periods

The international and global economy has continued to experience crisis for many years. The nominal and real exchange rates are affected on similar levels. Such aspects are affected by the various developments in the financial markets and the real sector. The Balassa-Samuelson model helps in minimizing violation of the exchange rate fluctuations. Such fluctuations affect the currencies during and post-crisis periods. The model helps in the determination of the exchange rates (Korteweg, 1982). They assist in the decision of the exchange rates since not only the traditional factors are used in determining the prices during the periods of crisis but also the anxiety among the market participants contribute towards determination of the exchange rates.

The model helps in reducing the tension that comes during and after the crisis. This form of pressure can result in policy interference in the foreign exchange markets. Such obstructions include intervention and capital controls. However, such interference has managed to solve the crisis through the comparison of the prior periods of severe global recession (Fidrmuc, Cuaresma & MacDonald, 2004). Provided with the conditions of the conflicts during the crisis and post-crisis periods, applying the Balassa-Samuelson model can be considered as a success.

There were increased expectations of the reorientation of the different monetary policies during and post-crisis. Such crisis resulted in the Central Bank to cut the interest rates severally. The interest rates gradually decreased as a result of the crisis. The model helps in reducing the effects of the crisis before they affected the real sector in all major currency areas (Korteweg, 1982). The investment in the currencies during the crisis was regarded as liquid and low-risk despite the nations where the crisis was considered to be the epicentre.

The model can be used where the variables comprise of the nominal exchange rate, the money stock and the industrial production. During the crisis and post-crisis periods, the model can be used in including the deposit interest rates and the ratio of consumer prices. Such rates can be used in capturing the deviations from the uncovered interest parity (Korteweg, 1982). The model helps in defining the deviations from the corresponding variables. During the crisis and post-crisis, the model helps in taking any relevant data from the IMF`s International Financial Statistics. The model eventually helps in complementing such data through the use of the various national sources.

References

Fidrmuc, J., Cuaresma, J. C., & MacDonald, R. (2004). The monetary approach to exchange rates in the CEECs.

Korteweg, P. (1982). Exchange Rate and Monetary Policy in a World of Real Exchange Rate Variability. In Exchange Rate Policy (pp. 135-169). Palgrave Macmillan, London.

Mihaljek, D., & Klau, M. (2008). Catching-up and inflation in transition economies: the Balassa-Samuelson effect revisited.

D. Intrest rate 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 9.84 6.13 5.57 6.9300000000000024 5.59 2.9099999999999997 1.9800000000000009 1.1100000000000001 0.3600000000000002 6 -0.4 -1.37 D. Inflation 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2.2030000000000012 4.5669999999999975 3.2149999999999999 0.77300000000000046 3.5819999999999999 0.26800000000000002 -1.849 -0.18000000000000013 -0.86600000000000055 0.21800000000000014 0.40700000000000008 D. Monetary growth 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 3.24 -17.79 -3.06 -8.08 -10.62 1.85 11.04 14.08 12.17 16.59 15.96