Analyze the effect of exchange rates on current account in oecd countries

1. Rationale of the research Exchange rates play a crucial role in international trade and can have significant implications for a countrys current account. The current account is a component of a countrys balance of payments, which measures the inflows and outflows of goods, services, income, and transfers. It represents the net balance of a countrys trade in goods and services with the rest of the world, along with net income flows and transfers. Exchange rate fluctuations can affect the current account balance through various channels, including trade competitiveness, import and export volumes, and income flows. Recognizing the importance and significance of this issue, in our research paper entitled Analyze the effect of exchange rates on current account in OECD countries, our team will focus on analyzing the overall impacts of exchange rate on the current account balance in countries belonging to OECD and provide some potential policies and solutions.

FACULTY OF BANKING AND

TABLE OF CONTENTS

INTRODUCTION 4

CHAPTER 1: LITERATURE REVIEW 6

CHAPTER 2: THEORETICAL FRAMEWORK 12

CHAPTER 3: RESEARCH MODEL AND RESULTS 16

3.1 Data description 16

3.1.1 Data collection and description 16

3.1.2 The statistical descriptions of the variables 16

3.1.3 Correlation description between the variables 17

3.2 Model specification 18

3.3 Estimation result 19

3.4 Discussion 20

CHAPTER 4: POLICY IMPLICATIONS 23

CONCLUSION 27

REFERRENCES 28

LIST OF TABLES

Table 3-1: Variables and sources of data collected 16

Table 3-2: Descriptive Statistics of variables 16

Table 3-3: Correlation matrix 17

Table 3-4: FGLS estimation result 19

1 Rationale of the research

Exchange rates play a crucial role in international trade and can have significantimplications for a country's current account

The current account is a component of a country's balance of payments, which measuresthe inflows and outflows of goods, services, income, and transfers It represents the netbalance of a country's trade in goods and services with the rest of the world, along withnet income flows and transfers Exchange rate fluctuations can affect the current accountbalance through various channels, including trade competitiveness, import and exportvolumes, and income flows

Recognizing the importance and significance of this issue, in our research paper entitled

"Analyze the effect of exchange rates on current account in OECD countries", our teamwill focus on analyzing the overall impacts of exchange rate on the current accountbalance in countries belonging to OECD and provide some potential policies andsolutions

2 Aims and Objectives of the research

The study aims to investigate the relationship between exchange rates and the currentaccount balances in these countries It seeks to understand how changes in exchange ratesaffect the current account, which is a key component of a country's balance of payments.The research may analyze factors such as foreign direct investment, economic growth andother relevant economic indicators to assess the impact of exchange rate fluctuations onthe current account position of OECD member countries The study could employ variouseconometric and statistical methods to analyze the data and draw meaningful conclusionsabout the effects of exchange rates on current accounts in the selected OECD members.The purpose of this study is an attempt to provide valuable information for policymakersand society, and at the same time to open the discussion in one of the important topics ininternational finance

3 Scope of the research

The subject of the study is the link between exchange rate and current account in 38countries in OECD

The scope of the study focuses on the period from 2013 to 2021 in selected countries inOECD

4 Research methods

The research uses the following methods:

Desk research method: This method is used to review research related to determinants ofcurrent account balance Specifically, the desk research method includes articles, articlespublished in scientific journals, summative reports, proceedings of scientific conferences,journals, and research papers on the given topic

Qualitative approach by comparative analysis method to analyze and summarize thesecondary data collected

Quantitative approach by regression method: the research applied the FeasibleGeneralized Least Squares (FGLS) for panel data to identify the influence/impact of theexplanatory factors on current account balance

5 Structure of the research

The structured study consists of five chapters:

Chapter 1: Introduction

Chapter 2: Literature review

Chapter 3: Theoretical framework

Chapter 4: Research model and

results Chapter 5: Policy implications

To complete the study, our team would like to thank Assoc Prof., PhD Mai Thu Hien forhelping the team in the process of carrying out and completing the research Due tocertain time and information constraints, as well as limitations on knowledge and skills,our team is looking forward to receiving comments, evaluations, and comments from theteacher so that the research paper will be more complete

CHAPTER 1: LITERATURE REVIEW

The literature on the determinants of the level and dynamics of the current account hasbeen examined by a large number of studies during the past decades and it is an importantissue for open economy macroeconomics There are different models with differentpredictions and choice of variables to understand which factors play a relevant role forcurrent account dynamics In this section we provide a summary of the most importantrelated research and empirical results, without providing a comprehensive overview

 “Determinants of Current Account Deficits in Developing Countries” by Cesar Augusto Calderon, Alberto Chong, and Norman V Loayza (2002)

The study analyzes current account deficits in a sample of 44 developing countries from

1966 to 1994 The findings suggest that these deficits exhibit a moderate level of persistencebeyond expected determinants, indicating a tendency for recurrent external deficits.Domestic output growth increases the current account deficit, although high-growthcountries do not necessarily experience larger deficits Improved growth in industrializedcountries reduces deficits in developing countries through increased export demand orshifts in investment patterns Public saving rates have a moderate impact in decreasing thecurrent account deficit, while private saving rates show no significant effect Changes inbalance of payments restrictions and foreign exchange rate restrictions do not consistentlyreduce deficits Additionally, an appreciation of the real exchange rate, worsening terms

of trade, and lower international real interest rates contribute to larger deficits The stages

of development hypothesis finds support as countries with lower per capita GDP relative

to industrialized countries tend to exhibit larger current account deficits Overall,these findings shed light on the complex dynamics of current account deficits indeveloping countries

 "The unsustainable US current account position revisited" by Maurice Obstfeld and Kenneth Rogoff

Obstfeld and Rogoff argue that exchange rate misalignments can significantly impact acountry's current account balance They discuss how sustained exchange rateundervaluation can lead to current account surpluses, while overvaluations can contribute

to deficits The authors highlight the potential role of speculative bubbles and capitalflows in driving misalignments The paper examines the sustainability of the US currentaccount deficit by analyzing various factors that contribute to external imbalances.Obstfeld and Rogoff discuss the implications of high net foreign liabilities and theinterplay between current account deficits, budget deficits, and national saving rates Theauthors explore the mechanisms through which the current account deficit adjusts overtime They discuss the role of exchange rate movements, price and income elasticities ofimports and exports, and the adjustment process in response to shocks Obstfeld andRogoff provide policy implications for addressing the US current account deficit andexternal imbalances more broadly They discuss the potential benefits of exchange rateadjustments, fiscal consolidation, and structural reforms to improve competitiveness anddomestic saving rates.

Based on the result, we can see the paper by Obstfeld and Rogoff provides acomprehensive analysis of the role of exchange rates in the US current account deficit Itoffers insights into the causes and consequences of external imbalances, as well aspotential policy measures to address these issues The authors' examination of exchangerate misalignments and their effects on the sustainability of the US current account deficitcontributes to the broader understanding of the relationship between exchange rates andcurrent accounts

However, the study still has limitation The research may focus on the specific case of the

US current account deficit, which may limit the generalizability of the findings to othercountries or contexts Exchange rate effects on the current account can vary across countriesdue to differences in economic structures, policy frameworks, and external factors

 Calderon et al (1999) “Current account deficits in Africa: stylized facts and basic determinants”

This is one of the first studies to focus on the determinants of the current account fordeveloping countries The authors use a panel data set of 44 developing countries withannual data for the period 1966–1995 The results indicate that GDP growth has a positiveimpact on the current account deficit; foreign (industrial countries) GDP growth reducesthe current account deficit; changes in private and public saving rates reduces the current

account deficit for the panel estimation but this effect does not hold for the cross section

analysis; a real exchange rate appreciation, terms of trade deterioration and lowerinternational real interest rates all increase the current account deficit; and countries withper capita GDP close to the industrial average have lower current account deficits (stages

of development hypothesis)

Recent empirical studies examining the determinants of the current account fordeveloping countries includes Calderon et al (2007) and they found that a real exchangerate appreciation and deterioration in the terms of trade are associated with a worsecurrent account deficit

 Aristovnik, A (2006) “The determinants and excessiveness of current account deficits in Eastern Europe and the former Soviet Union”

The article investigates the main factors of current account deficits in order to assess thepotential excessiveness of current account deficits in selected countries of Eastern Europeand the former Soviet Union According to the simulated benchmark calculated on thebasis of selected determinants (in period 1992-2003), the results confirm that the actualcurrent account balances are generally close to their estimated levels in the 2000-2003period in the transition region This notion is in line with the intertemporal approach tothe current account balance, suggesting that higher external deficits are a natural outcomewhen permanent domestic output exceeds the current one and when current investmentsand government consumption exceed their permanent levels Hence, the results suggestthat most countries in Eastern Europe and the former Soviet Union are justified in runningrelatively high current account deficits

Aristovnik (2006) concludes that real exchange rate appreciation and worsening tradeconditions increase the current account deficit The findings showed that countries withcurrent account deficits that were higher than 5% of their GDP encountered problem withdeficit sustainability

 Chinn, M., & Wei, S (2013) “A faith-based initiative: Does a flexible exchange rate regime really facilitate current account adjustment?” Journal of International Economics

The authors employ an empirical approach to analyze the relationship between exchangerate flexibility and current account adjustment To conduct their analysis, Chinn and Weiemploy a dataset covering 128 countries over the period from 1970 to 2007 They utilizeseveral econometric techniques to examine the relationship between exchange rateflexibility and current account adjustment.They use a panel dataset of countries and employvarious econometric techniques to estimate the effects of exchange rate flexibility on thecurrent account Chinn and Wei define exchange rate flexibility as the degree to which acountry allows its exchange rate to fluctuate freely in response to market forces Theymeasure exchange rate flexibility using different indicators, such as the degree ofexchange rate dispersion and the participation in exchange rate arrangements The paperfocuses on how exchange rate flexibility affects current account adjustment Currentaccount adjustment refers to the process by which countries' external imbalances, such astrade deficits or surpluses, are corrected over time.

The result is that greater exchange rate flexibility is associated with a smaller currentaccount adjustment In other words, countries with more flexible exchange rate regimestend to experience less significant changes in their current account balances The resultssuggest that flexible exchange rates may not necessarily facilitate rapid adjustments in thecurrent account

Chinn and Wei's study provides empirical evidence supporting the notion that a flexibleexchange rate regime can facilitate current account adjustment Their findings suggestthat exchange rate flexibility influences the price responsiveness of exports and imports,ultimately contributing to a more balanced current account However, it is important toconsider the limitations of the study and recognize that the effects of exchange rateflexibility may be influenced by various country-specific factors

 “The impact of the exchange rate on the foreign trade imbalance during the economic crisis in the new EU member states and the Western Balkan countries” by Miloš Rajković, Predrag Bjelić, Danijela Jaćimović & Miroslav Verbič (2020)

During the global economic crisis, the Western Balkan and Central and Eastern Europeancountries faced trade imbalances as a major challenge for sustainable economic growth

This paper contributes to the existing literature by validating and explaining the role offoreign exchange rates in establishing a sustainable trade balance, particularly in lessdeveloped countries The study finds that adjusting exchange rates became a strategy formaintaining trade balance equilibrium Fixed exchange rate countries experienced fasteradjustments and improved trade balances primarily through increased exports rather thanimport restrictions The research confirms that currency depreciation/devaluation caneffectively reduce trade imbalances by making exports cheaper and imports moreexpensive However, during the global economic crisis, the impact of the real exchangerate on the current account was reduced, limiting the effectiveness of devaluation as acorrective measure Public expenses, domestic and foreign demand, real interest rates,credit activity, and the level of a country's development also played significant roles intrade imbalances The transition to the Euro eliminated the possibility of improvingcompetitiveness through currency devaluation, further highlighting the importance ofother factors in trade equilibrium Further research is needed to explore the impact ofthese factors on trade balance during periods of external shocks.

 “Factors affecting current account balance of Turkey: A survey with the cointegrating regression analysis” by Gokhan Ozdamar

The Turkish economy has experienced steady real economic growth, but faces the challenge

of an increasing current account deficit The study analyzes the factors influencing thecurrent account balance in Turkey using quarterly data from 1994 to 2014 The results show

a strong relationship between the current account balance and foreign trade balance, GDP,and terms of trade However, the effects of domestic interest rates and real effectiveexchange rates are found to be insignificant Improving the current account balance requiresaddressing trade imbalances, increasing high-tech exports, reducing import dependence,and considering the impact of interest rates on consumption and import demand Policiesaimed at enhancing competitiveness and reducing reliance on intermediate goods arecrucial

Based on the given literature, the group of authors identify the research hypotheses asfollow:

H1: Real Effective Exchange Rate (indices) have a positive significant impact on the current account balance

H2: Net inflow FDI has a negative significant impact on the current account balanceH3: GDP growth rate has a positive significant impact on the current account balanceforimproving the current account balance and reducing economic risks

CHAPTER 2: THEORETICAL FRAMEWORK

The theoretical framework section of this study aims to provide a comprehensiveunderstanding of the relationship between exchange rates and the current account inOECD countries To achieve this, we draw upon various economic theories andframeworks that offer valuable insights into this complex relationship In this section, wewill explore several key theories, including the Mundell-Fleming model, PurchasingPower Parity (PPP), Elasticities Approach, Balance of Payments Constrained GrowthTheory, and New Open Economy Macroeconomics By examining these theories, we willestablish a solid foundation for analyzing the impact of exchange rates on the currentaccount and gain a deeper understanding of the underlying mechanisms

The Mundell-Fleming model, also known as the IS-LM-BP model, is an economicframework that explores the relationship between exchange rates, interest rates, output,and the balance of payments (Mundell & Fleming, 1963) It provides insights into howchanges in exchange rates impact the current account Here are the implications of theMundell- Fleming model for the current account under exchange rate changes:

 Price Effect: According to the Mundell-Fleming model, an exchange rate

depreciation (i.e., a decrease in the value of a country's currency) leads to anincrease in the price of imported goods and a decrease in the price of exportedgoods This price effect influences the trade balance, which is a component of thecurrent account The model suggests that a depreciation of the domestic currencyimproves the trade balance by making exports relatively cheaper and importsrelatively more expensive, thus leading to an improvement in the current account

 Income Effect: The income effect in the Mundell-Fleming model refers to the

impact of exchange rate changes on a country's income or output A depreciation

of the domestic currency stimulates exports and reduces imports, which leads to anincrease in net exports This increase in net exports contributes to an increase inaggregate demand and output in the economy Higher output, in turn, affects thecurrent account by influencing imports and exports

 Capital Flows: The Mundell-Fleming model also considers capital flows and their

impact on the current account When exchange rates change, it affects the relativeattractiveness of domestic and foreign assets An exchange rate depreciation canmake domestic assets relatively cheaper for foreign investors, leading to an inflow

of capital into the country This capital inflow affects the current account byinfluencing the financial account, which is a component of the balance ofpayments An increase in capital inflows can lead to a surplus in the currentaccount

 Interest Rate Parity: The Mundell-Fleming model incorporates the interest rate

parity condition, which suggests that changes in interest rates can affect exchangerates Under the model, an increase in domestic interest rates attracts foreigninvestors seeking higher returns This increase in demand for the domesticcurrency leads to an appreciation of the exchange rate An appreciation can have anegative impact on the current account by making exports relatively moreexpensive and imports relatively cheaper, potentially leading to a deterioration inthe trade balance

The Mundell-Fleming model implies that exchange rate changes can have both short-termand long-term effects on the current account The model highlights the interplay betweenexchange rates, interest rates, output, and capital flows in determining the impact ofexchange rate changes on the current account balance

In addition to the Mundell-Fleming model, several other economic theories and frameworksoffer insights into the relationship between exchange rates and the current account Thesetheories complement and expand our understanding of how exchange rate changes affectthe current account Here are the theories:

 Purchasing Power Parity (PPP): The PPP theory suggests that in the long run,

exchange rates adjust to equalize the purchasing power of different currencies(Rogoff, 1996) According to PPP, exchange rate changes impact the relativeprices of goods and services across countries, influencing trade flows and thecurrent account If a country's currency appreciates, its goods become relativelymore expensive, leading to a decline in exports and potentially worsening the

current account balance.

 Elasticities Approach: The elasticities approach emphasizes the responsiveness of

trade volumes to changes in relative prices It considers the price elasticities ofdemand for imports and exports When exchange rates change, they alter therelative prices of goods, which can affect the quantity of imports and exports Ifdemand elasticities are high, currency depreciation may lead to a significantincrease in export volumes and a decrease in import volumes, thus improving thecurrent account (Helpman et al., 2008)

 Balance of Payments Constrained Growth Theory: This theory posits that a country's

economic growth is constrained by its ability to generate sufficient foreign exchangeearnings through exports to finance its imports (Thirlwall, 1979) Exchange ratechanges influence export competitiveness and the availability of foreign exchange

If a currency depreciation improves export competitiveness and boosts exportearnings, it can contribute to a more favorable current account balance and supporteconomic growth

 New Open Economy Macroeconomics: New Open Economy Macroeconomics

(NOEM) models build upon the Mundell-Fleming framework and incorporateadditional features such as imperfect competition, nominal rigidities, andheterogeneous firms These models analyze the interactions between exchange rates,trade, and other macroeconomic variables They provide insights into how factorslike market structure, pricing behavior, and productivity affect the relationshipbetween exchange rates and the current account (Obstfeld & Rogoff, 2000)

This section has explored a range of economic theories and frameworks that shed light onthe relationship between exchange rates and the current account in OECD countries TheMundell-Fleming model provides a foundational understanding of the macroeconomicdynamics involving exchange rates, interest rates, output, and the balance of payments.Additionally, theories such as Purchasing Power Parity, Elasticities Approach, Balance ofPayments Constrained Growth Theory, and New Open Economy Macroeconomicscontribute to our understanding of how various factors influence the current account Byincorporating these theories into our analysis, we aim to uncover the nuanced mechanisms

that underlie the impact of exchange rates on the current account in the context of OECDcountries.