Exchange rate volatility and the level of domestic investment in selected European countr
ABSTRACT
The effects of exchange rate volatility on domestic investment is an important issue since the ending of Bretton Woods system in 1973. Most studies argue that exchange rate volatility leads price volatility. Price volatility could have positive or negative effects on domestic investment. The Empirical literature provides mixed results.
In this paper, this issue is investigated for selected European Countries; those that adopted the Euro in 1999. In addition to searching the effect of exchange rates on investment levels, the paper also investigates how this effects differs according to the main macro economic indicators of the countries.
For this purpose two methodologies are used. Firstly, an investment model is developed and estimated by panel methodology by employing quarterly data between 1999 and 2012. As explanatory variables, credit to GDP ratio, real interest rates, trade balance, and crises dummies are used in the model. As a robustness test, difference-in-differences (DD) methodology is also applied. Secondly, the same investment model is used to estimate a long run relationship between variables by using the same data set. Since the use of non-stationarity time series produce spurious results, data sets are investigated for stationarity. After establishing the stationarity of the data series, a cointegration test is performed and following the cointegration test and error correction is developed and estimated.
The creation of an exchange rate risk variable is one important issue in this paper. For this purpose we developed an ARIMA model. This model is used to estimate conditional variance from the GARCH procedure and this conditional variance is used as the relevant measure of real exchange rate uncertainty.
This study would expected to shed some light on the issue of mixed results in the relevant literature. We would expect to find explanations for both positive and negative effects of exchange rate volatility on domestic investments.
Key words: Exchange rate risk, Investment, Panel Methodology, Error Correction
JEL CODES : C01 E22 052