The Determinants of the Real Exchange Rate and the Role of These Fundamental Factors in New Zealand's Economy

ABSTRACT: The aim of this study is to empirically investigate the determinants of the real exchange rate and the role of these fundamental factors in New Zealand economy. Following the framework introduced by Edwards (1989) and Domac and Shabsigh (1999), some additional variables are modified within their model to find out whether there is a relationship between real exchange rate and its economic determinants. Multivariate cointegration, Granger causality and unit root techniques are applied to identify this relationship using a sample of quarterly data covering the period of 1974Q1 - 2009Q3. This thesis also checked the validity of the model and the relative importance of different variables which may have an impact on the real exchange rate policy of New Zealand economy. In the light of the empirical evidence, there exists a relationship between real exchange rate and independent variables – openness, the growth of nominal exchange rate, relative productivity, government consumption, and domestic credit. These variables have an impact on the real exchange rate and the real exchange rate increase when the degree of openness and growth of the nominal exchange rate rise while, relative productivity, the government consumption and domestic credit decrease. However, capital inflows and terms of trade are insignificant in explaining the movement in the equilibrium of real exchange rate. Based on the findings estimated, the New Zealand’s government could consider following issues for policymaking in case of the real exchange rate: (i) there are more significant variables exist in the fixed exchange rate regime therefore, a much wider range of tools are available for policymaking, (ii) in the long-run; openness, growth of nominal exchange rate, relative productivity, government consumption and domestic credit play an important role in keeping the real exchange rate in an appropriate level while, for the short-run, only openness, growth of nominal exchange rate and relative productivity are significant, and (iii) openness explain the greatest component of the variation in the real exchange rate in long-run while, relative productivity is the most significant variable in short-run. Keywords: New Zealand Economy, Real Exchange Rate, Unit Root, Granger Causality, Co integration. ……………………………………………………………………………………………………………………………………………………………………………………………………………………