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Journal of Social and Business Studies
ISSN: 2303-6044
Vol. 1(1) / pp.1-10
Short-Run Determinants of the HRK/USD Exchange Rate and Policy Implications
Yu Hsing
Southeastern Louisiana University
United States of America
[email protected]
Abstract
This paper examines short-run determinants of the Croatian kuna/U.S. dollar
Article History
(HRK/USD) exchange rate based on a simultaneous-equation model. Demand
Submitted: 17 July 2014
and supply analysis is employed to examine the behavior of the HRK/USD
Resubmitted: 31 July 2014
exchange rate. Comparative static analysis is used to determine the impact of a
Accepted: 12 August 2014
change in an exogenous variable on the equilibrium exchange rate. The
EGARCH model is applied in empirical work. Major findings are that the
HRK/USD exchange rate is positively associated with the real 10-year U.S.
government bond yield, real GDP in Croatia, the real stock price in the U.S.
and expected exchange rate and is negatively influenced by real GDP in the
U.S. and the real stock price in Croatia.
Keywords: exchange rate determination; interest rates; output, stock prices;
EGARCH
JEL Classification: F31, F41
Citation:
Hsing, Y. (2014). Short-Run Determinants of the HRK/USD Exchange Rate and Policy Implications. Journal of Social and
Business Studies, 1(1), 1-10
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Yu Hsing
Journal of Social and Business Studies
ISSN: 2303-6044
1. Introduction
International trade has become more important in economic growth in Croatia. In 2013, the amount of
exports as a percent of GDP was 42.97%, and the amount of imports as a percent of GDP was 42.42%,
suggesting that Croatia had a relatively high trade openness index of 85.39%. To pursue a balanced
trade or to avoid a trade deficit, the exchange rate plays a pivotal role. Mainly due to the global
financial crisis, the Croatian kuna had depreciated 20.79% versus the U.S. dollar from 4.59398 in
2008.Q1 to 5.549 in 2013.Q4. While depreciation of the kuna would lead to more exports, it is
expected to have some negative effects such as higher costs of imports, import-led inflation,
international capital outflows, etc.
A volatile exchange rate is expected to hurt international trade and economic growth because importers
and exporters are uncertain about costs of exchange for foreign currencies and profits or losses that
trade may have. A substantially over-valued currency would be difficult to maintain as a government
needs to continue to sell foreign reserves to defend the domestic currency and may result in a potential
speculative attack. A substantially under-valued currency would help exports but may be subject to
external pressures to move it to the fundamental value.
This paper attempts to use demand and supply analysis to explain fluctuations of the HRK/USD
exchange rate in order to provide policymakers insights in conducting monetary policy and fiscal
policy to stabilize exchange rates and to pursue economic growth.
In the second section, literature will be surveyed. In the third section, the methodology will be
presented. In the fourth section, the data and empirical results will be reported and analyzed. A
conclusion will be made in the last section.
2. Literature Review
There have been several studies examining the determinants of exchange rates for Croatia or related
countries. Baharumshah and Borsic (2008) study purchasing power parity (PPP) for 13 Central and
Eastern European countries and find that PPP is valid for Croatia if either the U.S. dollar or the euro is
used. Tkalec and Vizek (2011) shows that absolute purchasing power parity holds for Croatia in the
long run, suggesting that the exchange rate is in accord with the fundamentals. They also report that
exchange rate pass-through to the domestic consumer price is not confirmed. Miteza (2012) examines
PPP for 6 Central and East European countries and finds that PPP is confirmed for four of six countries
and that the is very strong evidence of PPP for Slovakia, Poland and the Czech Republic. Kozul (2013)
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Yu Hsing
Journal of Social and Business Studies
ISSN: 2303-6044
tests whether PPP applies to the Croatian kuna/euro exchange rate based on ADL and Engle-Granger
tests and finds that PPP does not hold for Croatia.
Funda and Lukinić (2008) indicate that the Balassa-Samuelson effect in Croatia is not confirmed and is
not expected to become an obstacle to satisfying the convergence criteria. Erjavec, Cota and Jakšić, S.
(2012) reveal that the main reason for the volatility of the Croatian kuna exchange rate comes from
demand shocks instead of supply shocks in the short run and long run. Hence, the exchange rate serves
as a shock absorber.
To the author’s best knowledge, few of these studies have applied demand and supply analysis in
foreign exchange markets to determine the HRK/USD exchange rate in the short run. Monetary models
of exchange rates are based on the validity of purchasing power parity in the long run. In addition to
interest rates or stock prices, exchange rates may be affected by other variables. This paper attempts to
examine the HRK/USD exchange rate based on a simultaneous-equation model. The demand for and
the supply of the U.S. dollar versus the Croatian kuna are considered simultaneously in determining the
equilibrium HRK/USD exchange rate. A study of the determinants of the HRK/U.S. dollar exchange
rate would provide policymakers with more insights into the behavior of the kuna and other currencies.
3. Methodology
We can express the demand for and supply of the U.S. dollar versus the Croatian kuna in the foreign
exchange market as:
USD d  A( , Y HR , RUS , E US ,  e )
(1)
−+ +
+ +
US
HR
USD  B( , Y , R , E HR )
(2)
s
++
where
USDd
USDs
ε
YHR
RUS
EUS
εe
YUS
+
+
= demand for the U.S. dollar,
= supply of the U.S. dollar,
= the HRK/USD (Croatian kuna/U.S. dollar) exchange rate,
= real GDP or income in Croatia,
= the real interest rate in the U.S.,
= the real equity or stock price in the U.S.,
= the expected HRK/USD exchange rate,
= real GDP or income in the U.S.,
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Yu Hsing
RHR
EHR
Journal of Social and Business Studies
ISSN: 2303-6044
= the real interest rate in Croatia,
= the real equity or stock price in Croatia.
We expect that the demand for the U.S. dollar has a negative relationship with the HRK/USD exchange
rate and a positive relationship with real GDP or income in Croatia, the real interest rate in the U.S., the
stock price in the U.S., and the expected HRK/USD exchange rate. The supply of the U.S. dollar is
expected to be positively associated with the HRK/USD exchange rate, real GDP or income in the U.S.,
the real interest rate in Croatia, and the stock price in Croatia. As real GDP or income in Croatia rises,
Croatians tend to import more goods and services from the U.S. and increase the demand for the U.S.
dollar. When real GDP or income in the U.S. rises, Americans tend to import more goods and services
from Croatia and increase the supply of the U.S. dollar in exchange for the Croatian kuna. A higher real
interest rate or stock price in the U.S. tends to attract Croatians to invest in these financial assets and to
increase the demand for the U.S. dollar. On the other hand, a higher real interest rate or stock price in
Croatia tends to attract American investors to buy these financial assets and increase the supply of the
U.S. dollar in exchange for the Croatian kuna.
Solving for the equilibrium values of the two endogenous variables simultaneously, we can express the
equilibrium exchange rate as a function of all the exogenous variables:
  f ( RUS , R HR , Y US , Y HR , E US , E HR ,  e )
(3)
Comparative static analysis shows that a change in any one of the exogenous variables is expected to
have an impact on the equilibrium HRK/USD exchange rate
 / RUS   ARUS / J  0
(4)
 / R HR   BR HR / J  0
(5)
 / Y US   BY US / J  0
(6)
 / Y HR   AY HR / J  0
(7)
 / E US   AEUS / J  0
(8)
 / E HR   BE HR / J  0
(9)
 /  e   A e / J  0
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(10)
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Yu Hsing
Journal of Social and Business Studies
ISSN: 2303-6044
where J  ( A  B ) is the Jacobian for the endogenous variables and has a negative value.
Note that in the monetary models based on the equilibrium condition in the money market, the sign of
the interest rate differential between Croatia and the U.S. may be positive or negative, depending upon
whether the Bilson (1978) model or the Dornbusch (1976) and Frankel (1979) models would apply.
Furthermore, the traditional view suggests that an increase in the interest rate would cause a currency to
appreciate whereas the revisionist view shows that a higher interest rate would cause a currency to
depreciate due to a higher default probability, a weaker financial position of firms that are debt
constrained, and a higher exchange rate risk premium (Huang, Hueng and Yau, 2010).
4. Empirical Results
The data were collected from the International Financial Statistics, which is published by the
International Monetary Fund. The HRK/USD exchange rate measures units of the kuna per U.S. dollar.
Hence, an increase means an appreciation of the U.S. dollar or a depreciation of the Croatian kuna. The
real interest rate in the U.S. is represented by the real 10-year government bond yield minus the
inflation rate in the U.S. Due to lack of data for the government bond yield, the real interest rate in
Croatia is represented by the government bond yield in the euro area minus the inflation rate in Croatia.
Real GDP in the U.S. or Croatia is an index number measured at the 2005 year. The expected exchange
rate is represented by the average HRK/USD exchange rate of past four quarters. The stock price in the
U.S. is represented by the share price in the U.S., and the stock value in Croatia is measured by the
share price in Croatia. The sample consists of quarterly data ranging from 1997.Q3 to 2013.Q4 and has
a total of 66 observations.
The ADF test on the regression residuals is employed to determine whether these time series variables
are cointgegrated. The value of the test statistic is estimated to be -3.3381, which is greater than the
critical value of -2.6016 in absolute values at the 1% level. Therefore, these variables have a long-term
stable relationship.
Table 1 presents estimated coefficients and other related statistics. The EGARCH method is applied in
empirical estimation in order to yield a positive conditional variance without restriction on the
parameters. As shown, 90.53% of the change in the equilibrium HRK/USD exchange rate can be
explained by the right-hand side variables. Except for the coefficient of the real government bond yield
in the euro area, other coefficients are significant at the 1% level. The equilibrium HRK/USD exchange
rate is positively associated with the real 10-year U.S. government bond yield, real GDP in Croatia, the
real stock price in the U.S., and the expected exchange rate. It is negatively affected by real GDP in the
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Yu Hsing
Journal of Social and Business Studies
ISSN: 2303-6044
U.S. and the real stock price in Croatia. The negative coefficient of the real government bond yield in
the euro area is insignificant at the 10% level.
Several comments can be made. It appears that the coefficient of any variable for the U.S. is greater
than the coefficient of the corresponding variable for Croatia in absolute values. A 1 percentage-point
increase in the real 10-year U.S. government bond yield would raise the HRK/USD exchange rate by
0.1034. A 1 unit increase in U.S. real GDP would reduce the HRK/USD exchange rate by 0.0071
whereas a 1 unit increase in the Croatian real GDP would raise the HRK/USD exchange rate by 0.0021.
A one unit increase in the stock price index in the U.S. would increase the HRK/USD exchange rate by
00130 whereas a one unit increase in the stock price index in Croatia would reduce the HRK/USD
exchange rate by 0.0048. If the expected exchange rate rises by 1, the actual exchange rate would
increase by 0.7563.
Table I. Estimated Regression of the HRK/USD Exchange Rate
Dependent variable: HRK/USD exchange rate
Real 10-year U.S. government bond yield
Real euro government bond yield
Real GDP in the U.S.
Real GDP in Croatia
Real stock price in the U.S.
Real stock price in Croatia
Expected HRK/USD exchange rate
Constant
R2
Mean absolute percent error
Sample period
Number of observations
Methodology
Coefficient
0.1034
-0.0065
-0.0071
0.0021
0.0130
--0.0048
0.7563
1.0161
z-statistics
20.0003
-1.4698
-21.5008
3.4653
16.8446
-22.7988
70.8176
6.7125
0.9053
4.3680%
1997.Q132013.Q4
66
EGARCH
Notes: Except for the coefficient of the real euro government bond yield, other coefficients are significant at the 1% level.
HRK stands for the Croatian kuna.
Several other versions are tested to determine whether the results may change. If the real euro
government bond yield is replaced by the real deposit rate in Croatia, its coefficient is negative but
insignificant at the 10% level. The R2 value of 0.9055 is very similar to the R2 value of 0.9053 as
reported in Table 1. Except for the real government bond yields with negative values, when the log
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Yu Hsing
Journal of Social and Business Studies
ISSN: 2303-6044
form is used, only the coefficients of the real U.S. government yield and the real stock price in Croatia
are significant whereas other coefficients are insignificant at the 10% level.
5. Summary and Conclusions
This paper has examined the determinants of the HRK/USD exchange rate in the short run based on a
simultaneous-equation model consisting of the demand for and supply of the U.S. dollar. A reducedform equation is estimated by the EGARCH method. The paper finds that a higher real U.S.
government bond yield, a higher real GDP in Croatia, a higher real stock price in the U.S., and a higher
expected exchange rate would raise the HRK/USD exchange rate whereas a higher U.S. real GDP and a
real higher stock price in Croatia would reduce the HRK/USD exchange rate.
There are several policy implications. It seems that demand and supply analysis of exchange rates in
the short run works reasonably well as it can explain approximately 90.53% of exchange rate
movements. The forecast error of 4.368% is relatively small. Interest rates, real GDP, stock prices and
the expected exchange rate in the U.S. and/or Croatia play important roles in exchange rate movements
in the short run. Recent higher real U.S. government bond yields or rising U.S. stock prices tend to
raise the HRK/USD exchange rate. Recent higher real government bond yields in the euro area or
higher U.S. real GDP would reduce the HRK/USD exchange rate. The current weaker economy in
Croatia is likely to put smaller downward pressure on the HRK/USD exchange rate. Relatively stable
stock prices in Croatia tend to stabilize the HRK/USD exchange rate.
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