Page |i

Impact of Macroeconomic Variables on the Exchange

Rate in Bangladesh
By
Kazi Asequl Arefin

Id: 1304070

Emtiaz Hossain Hritan

Id: 1304084

Ehtasham Ul Haq

Id: 1304033

Marium Mahmuda Zaman

Id: 1304035

Saeed Ahamed

Id: 1304048

A Research Paper Submitted to

Dr. Sumon Das

Associate Professor
Faculty of Business Studies, BUP

In fulfillment of the requirements

For the Course,
International Financial Management (FIN- 4606)

Bangladesh University of Professionals,

Mirpur Cantonment
October 19, 2016

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LETTER OF TRANSMITTAL
October 19, 2016
Dr. Sumon Das,
Assistant Professor,
Faculty of Business Studies,
Bangladesh University of Professionals.
Subject: Submission of term paper on Impact of macroeconomic variables on the exchange rate
in Bangladesh
Dear Sir,
This is our great pleasure to have the opportunity to submit the term paper on the topic of
Impact of macroeconomic variables on the exchange rate in Bangladesh as part of our course
studies.
The term paper is prepared based on our analysis of related theories collected from books and
websites. We sincerely hope and believe that these findings will be able to meet the requirements
of the course.
Therefore we would like to place this term paper for your kind judgment and valuable
suggestion.
Sincerely yours,

Kazi Asequl Arefin

ID:1304070

Ehtasham Ul Haq
ID: B1304033

Saeed Ahamed
ID: B1304048

Emtiaz Hossain Hritan

ID: B1304084

Marium Mahmuda Zaman

ID: B1304035

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BONAFIDE CERTIFICATE
Certified that this project report titled Impact of macroeconomic variables on the
exchange rate in Bangladesh is the bonafide work of Kazi Asequl Arefin (ID: B1304070),
Emtiaz Hossain Hritan (ID: B1304084), Ehtasham Ul Haq (ID: 1304033), Marium Mahmuda
Zaman (ID: 1304035), Saeed Ahamed (ID: 1304048) who carried out the project work under my
supervision. Certified further that, to the best of my knowledge the work reported herein does not
form part of any other project report or dissertation on the basis of which a degree or award was
conferred on an earlier occasion or any other candidate.

Signature of Faculty
Dr. Sumon Das
Associate Professor, FBS, BUP

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ABSTRACT

The exchange rate of a country has a significant effect on the direction of foreign trade. As part
of a developing country, Bangladesh Bank must closely monitor all potential variables affecting
the exchange rate against major currencies. As flexible exchange rate creates volatility, these
variables must be controlled to maintain the stability of the exchange rate. This study aims to
find out the major macroeconomic variables affecting the exchange rate. The linear regression
analysis is carried out to find the relationship. Current account balance, GDP growth rate and
Relative interest rate were selected as explanatory variables. Correlation analysis was carried out
between the explanatory variables to find out the reliability of the analysis. The regression
parameters were estimated using the Ordinary least square method. The results were tested with
t-test and F-test to find out the statistical significance. The data of exchange rate, GDP growth,
relative interest rates and relative inflation from year 1976 to 2015 in order to fully understand
the impacts of the explanatory variables. The selected explanatory variables all had positive
relationship with the exchange rate of Bangladesh. All parameters were found statistically
significant. It was also found out the exchange rate of Bangladesh is appreciating slowly day by
day. From the results of this study, we conclude that the economic fundamentals have a definite
affect on exchange rate and the central bank of the country should monitor and control the
variables as far as possible to maintain a stable exchange rate.

Keywords: Exchange Rate, Factors affecting exchange rate, Relative interest rate, Regression
analysis

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Acknowledgement

First and above all, we praise God, the almighty for providing me this opportunity and
granting me the capability to proceed successfully. This research paper appears in its
current form due to the assistance and guidance of several people. We would therefore
like to offer my sincere thanks to all of them.

We would like to cordially thank our course teacher, Dr. Sumon Das for giving us the
opportunity to work in this topic. We would also like to thank him for his insightful discussion,
offering valuable advice and support during the whole period of study.

Special thanks go to our team mate, Kazi Asequl Arefin and Emtiaz Hossain Hritan, who
spearheaded the project and gave suggestion about every part of this report. Last but not least,
many thanks go to our other members, Marium Mahmuda Zaman, Ehtasham Ul Haq and Saeed
Ahamed who have invested their full effort in propelling the team forward to achieve its goal.

We also place on record, our sense of gratitude to one and all, who directly and indirectly, have
lent their helping hand in this venture.

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Table of Contents
ABSTRACT................................................................................................................................................. iv
GLOSSARY ............................................................................................................................................... vii
1.1 BACKGROUND OF THE STUDY ....................................................................................................... 2
1.2 STATEMENT OF THE RESEARCH PROBLEM ................................................................................ 4
1.3 SIGNIFICANCE AND RATIONALE OF THE STUDY ...................................................................... 4
1.4 OBJECTIVES ......................................................................................................................................... 5
1.5 SCOPE AND LIMITATIONS ................................................................................................................ 6
2.0 LITERATURE REVIEW ....................................................................................................................... 8
3.1 POPULATION PARAMETERS .......................................................................................................... 11
3.2 SAMPLING DESIGN .......................................................................................................................... 11
3.3 VARIABLES COVERED .................................................................................................................... 11
3.4 METHODS OF DATA COLLECTION AND INSTRUMENTS USED IN DATA COLLECTION .. 12
3.5 DATA PROCESSING AND ANALYSIS/DATA ANALYSIS PLAN ............................................... 12
4.0 STUDY RESULTS AND FINDINGS .................................................................................................. 14
4.1 THEORETICAL BACKGROUND ...................................................................................................... 14
4.1.1 Factors affecting exchange rate.......................................................................................................... 14
4.1.2 Relationship between Exchange Rate and GDP growth .................................................................... 15
4.1.3 Relationship between Exchange Rate and Current Account Balance ................................................ 15
4.1.4 Relationship between Exchange Rate and Relative Interest Rate ...................................................... 16
4.2 CORRELATION ANALYSIS AND INTERPRETATION ................................................................. 17
4.3 DESCRIPTIVE STATISTICS .............................................................................................................. 19
4.4 REGRESSION ANALYSIS AND INTERPRETATION ..................................................................... 19
4.4.1 Output of Regression Analysis .......................................................................................................... 21
4.4.2 Interpretation of Regression Analysis ................................................................................................ 21
4.4.3 Significance Testing........................................................................................................................... 22
4.5 ANOVA ANALYSIS ........................................................................................................................... 23
4.6 SUMMARY OF FINDINGS ................................................................................................................ 24
5.1 CONCLUSION ..................................................................................................................................... 26
5.2 RECOMMENDATIONS ...................................................................................................................... 26
APPENDIX 1 .............................................................................................................................................. 28
REFERENCES ........................................................................................................................................... 30

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GLOSSARY

ANOVA- Analysis of Variance

Balance of Payments -The balance of payments of a country is the record of all economic
transactions between the residents of the country and the rest of the world in a particular period
BOP-Balance of Payments
Cross Exchange Rate-A cross rate is the currency exchange rate between two currencies when
neither are official currencies of the country in which the exchange rate quote is given.
Current Account Balance- The difference between a nations savings and its investment.
Exchange rate- In finance, an exchange rate between two currencies is the rate at which one
currency will be exchanged for another. It is also regarded as the value of one countrys currency
in relation to another currency.
Explanatory variable-An explanatory variable is any factor that can influence the response
variable. An explanatory variable attempts to explain the observed outcomes.
Factor Income- Earnings on foreign investments minus payments made to foreign investors
FDI-Foreign Direct Investment
Fixed Exchange Rate-A fixed exchange rate is a country's exchange rate regime under which the
government or central bank ties the official exchange rate to another country's currency or to the
price of gold.
Floating Exchange Rate-A floating exchange rate or fluctuating exchange rate is a type of
exchange-rate regime in which a currency's value is allowed to fluctuate in response to foreignexchange market mechanisms.
GDP-Gross Domestic Product
GNP-Gross National Product
LCU-Local currency Unit

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Managed Floating Exchange Rate- Managed float regime is the current international financial
environment in which exchange rates fluctuate from day to day, but central banks attempt to
influence their countries' exchange rates by buying and selling currencies.
MLA- Maximum Likelihood Estimate
MNC-Multi-National Corporation
NNP-Net National Product
OLS-Ordinary least squares
Scatter Plot- Scatter plots show how much one variable is affected by another. The relationship
between two variables is called their correlation.
Trade Balance- The trade balance, also known as the balance of trade (BOT), is the calculation
of a country's exports minus its imports.

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Chapter 1: Introduction

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1.1 BACKGROUND OF THE STUDY

Exchange rate fluctuation or stability is the major concern which determines the direction of
foreign trade and commerce. Exchange rate fluctuation and its effect on the volume of
international trade is an important subject for empirical investigation, after the adoption of
floating exchange rate 1973. The exchange rate is defined as the domestic price of a unit of
foreign currency. Exchange rate can be called the conversion factor that determines the rate of
change of currencies. Real and nominal exchange rates are different from each other. If the
researchers leave out the inflation influence then it is real exchange rate and if the researchers
incorporate the inflation influence then it is nominal exchange rate. The nominal exchange rate
can be expressed in bilateral and multilateral term. Real exchange rate volatility means the short
term oscillation of the real exchange rate. A different pattern of exchange rate behavior into
categories is known as exchange rate regime. In which exchange rate remains fixed is called fix
exchange rate regime and in which exchange rate fluctuates is known as floating exchange rate
regime. The middle of fix and floating exchange rate is called managed float regime.
Macroeconomic variables such as interest rate, inflation rate, the balance of payments, tax rate
etc influence the exchange rate randomly. These macroeconomic variables are unstable and
volatile depending on the state of the economy prevailing in their countries. In addition increased
cross border currency flows due to foreign direct investment and service like banking, insurance,
education, tourism cause the exchange rate fluctuate randomly. Advent of on line trading,
currency speculation is rampant and cause exchange rates to fluctuate. The role of exchange rate
in imports and exports is crucial. In addition a countrys overall economic performance is
reflected by exchange rate. Macroeconomic variables prevail in home and host countries
determine the exchange rate equilibrium in long-run. Short-run fluctuations are temporary caused
by arrival of economic information from time to time from home and host countries. Increasingly
the incoming and outgoing foreign direct investments create massive capital flows and directly
influence exchange rate. Even counties which follow floating rate and non-intervention policy
sometimes feel uncomfortable when the exchange rate becomes volatile. Fluctuations of
exchange rate have significant impact on countries import and export behavior and ultimately
culminate in current account balance and foreign currency reserves held by the central banks.
Recent global economic turmoil affected significantly different systems of economy. Exchange

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rate is not an exception as it is closely aligned to macroeconomic variables. Country with an

appreciating home currency will experience its goods become more expensive in international
market which may affect the exports and at the same time imports become inexpensive. This is a
double blow to the home country which will rapidly affect the BOP. In contrast if domestic
currency depreciates, imports will be expensive in the domestic market and local companies
would find their goods more attractive due to lower prices in international markets.
Exchange rate not only influences imports, exports and direct investments but also several
service sectors like banking, insurance, education, tourism. In addition consolidation of financial
statements of foreign subsidiaries with domestic parent also becomes cumbersome. While
translating foreign subsidiary financial statements in home currency the exchange rates paly the
spoil shot. Exchange rates extensively deflate or inflate profit and asset values of the foreign
subsidiary as the opening and closing exchange rates substantially differ, thereby creating a
situation where mandatory manipulation is permissible which ultimately results in wrong
reporting. The pertinent example is Enron.
The gross domestic product (GDP) is one the primary indicators used to determine the health of a
country's economy. It represents the total dollar value of all goods and services produced over a
specific time period the researchers can think of it as the size of the economy. Usually, GDP is
expressed as a comparison to the previous quarter or year. For example, if the year-to-year GDP
is up 3%, this is thought to mean that the economy has grown by 3% over the last year.
Economists have long known that poorly managed exchange rates can be disastrous for
economic growth. Avoiding significant overvaluation of the currency is one of the most robust
imperatives that can be gleaned from the diverse experience with economic growth around the
world, and one that appears to be strongly supported by cross-country statistical evidence (Razin
and Collins, 1997). Cheung and Lai (1998) considered the influence of relative factors such as
the per capita GDP to the foreign exchange reserves. Johansen (1988) thought that the foreign
exchange reserve of some countries with a rapid increase is the by-product of the undervalued
real exchange rate policy carried out by them aiming at promoting the export, not that these
national monetary and financial authorities are intended.
An important determinant which may cause volatility of exchange rate differentials, inflation
differentials and current account deficit, interest rate and last which is most important is GDP

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growth rate. How these factors affect the exchange rate and whats changing take place in overall
economy. Sound macroeconomic policies, inflation management may handle the difference in
exchange somehow which cause payment deficit. Proper understanding and management of
determinants of exchange rate give help and clear view towards developing sound exchange
policies to achieve desired economic growth. Investors may invest in that economy where
exchange rate is stable because in that type of economy where exchange rate volatility risk is
higher and risk aversion investors never invest in this type of economy. To boost up the economy
exchange rate must be managed for this purpose the determinants must be focused.

1.2 STATEMENT OF THE RESEARCH PROBLEM

One of the major criticisms against flexible exchange rate is, it creates volatility. Exchange rate
volatility induces uncertainty into international transactions. This uncertainty decreases
international trade and economic the welfare. Moreover, exchange-rate risk increases transaction
costs and reduces the gains to international trade. Under the managed floating exchange rate, the
central bank must control the exchange rate by keeping it within a predefined range. Substantial
time and resource is needed to control the exchange rate. Foreign exchange policies are
instrumental in mobilization of foreign savings and capital to fill the domestic resource gap and
expand investments. As a result, it is important to understand the existing relationship of
exchange rate with economic growth and other macroeconomic variables in Bangladesh to
justify the time and resources devoted to control the exchange rate.

1.3 SIGNIFICANCE AND RATIONALE OF THE STUDY

Bangladesh is said to be a country with great potentials. Though many consider it over burdened
with huge population, many other consider this population as asset. Talking the positive aspects,
this population can easily contributes economic growth Talking about the negative aspects, this
population requires a huge amount of daily necessities that may not be possible for Bangladesh
to produce and thus they are bound to go for foreign trade. Over the past few decades, the nexus
among Exchange rate and macroeconomic variables have drawn extensive attention of

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macroeconomists, policy makers and the central bankers of both developed and developing
countries. Specifically, the issue that whether exchange rate is necessary for economic growth or
it is harmful generates a significant debate both theoretically and empirically.
The research can be seem important in the point of view if the researchers analyze the variables
that the researchers use in this paper. The paper takes account of the inflation, interest, income,
government control and future exchange rate and creates a significant relation towards exchange
rate. These analysis will show which factors are highly correlated to the exchange rate, and with
this analysis, the economists can have a detailed idea of what factor needs to be improved, or
which factor need more intervention. With the information and findings of this research, the
concerned authority has the chance to use this knowledge to improve the main factors that shows
a significance, and use it to create a stable exchange rate suitable for positive expansion of the
countrys growth. Also, these research findings can be used as data for further researches, which
might bring about some changes on the approach of the exchange rates deviations, and create a
stable path for new business opportunities.

1.4 OBJECTIVES
General Objective
To determine the impact of macroeconomic variables on the exchange rate in Bangladesh

Specific Objectives
To find out the theoretical expected relationship between GDP growth, current account
balance, interest rate differentials and exchange rate.
To find out trend of exchange rate movement of Bangladesh
To construct a convincing model that is capable of explaining the movement of exchange
rate and predicting the exchange rate movement based on macroeconomic changes of
Bangladesh

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To understand the existing theories explaining relationship between exchange rate and
microeconomic factors.

Ultimate Objective
To understand the problems and prospects of international business of Bangladesh in
terms of exchange rate volatility to help in policy decisions and effective planning

1.5 SCOPE AND LIMITATIONS

The research has developed some scopes for the analysis.
The study will provide new revised and analyzed data for further extension of the
research or for the new research arise in the relative field.
The study will point out some of the main acting variable that controls or influences the
exchange rate deviations.
The study can be used for identifying the needed changes or revision of the current
monetary and exchange rate policies.
With much scope to offer, this study suffers from some limitations, which includes
This study only deals with only three explanatory macroeconomic variables while
excluding taxation, inflation, FDI etc
This study assumes GDP as only measure of economic growth ignoring GDP per capita
,GNP, NNP, GNI, United Nations Human Development Index (UNHDI), Genuine
Progress Indicator (GPI), and Gross Sustainable Development Product (GSDP)
This study only deals with secondary information which can be inaccurate, biased or
fabricated.
This study doesnt include any primary data for example- opinions of policymakers,
MNC managers, foreign investors
Time constraints and lack of expertise in complex macroeconomic phenomenon.

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Chapter 2: Literature Review

Page |8

2.0 LITERATURE REVIEW

Several studies have been carried out to explain the behavior of exchange rate in the long run and
in the short run. While most models explaining short run behavior of exchange rate failing to
verify empirically, the belief that exchange rate behavior is related to the market fundamentals in
the long run are still dominant in the current time.
Yong and Ling (1996) examined Purchasing Power Parity (PPP) and the monetary model for the
exchange rate between Singapore and US dollar. Since the absolute purchasing power parity is
not testable due to distortion, relative PPP is tested. They used cointegration analysis to find out
that the exchange rate is in agreement with the relative PPP. But the monetary model could not
explain the movements in the exchange rate.
Rogoff (2002) examined the validity of Dornbusch model, also called the overshooting model.
Although the model explains the movement of exchange rate after monetary policy
announcement, the model could not be verified empirically and also the model failed to establish
any systematic relationship between major currencies with flexible exchange rate.
Khan & Abbas (2015) examined the validity of the Portfolio Balance model, which is an
extension of monetary model. This model proposes that the supply-demand situation of domestic
and foreign bonds and the supply demand situation of domestic and foreign money determine the
exchange rate. They used Augmented Dickey Fuller and Phillips Perron test and analyzed the
data with Auto regressive distributed lag model. The results indicate long term relationship
among the variables.
Zaman and Bakshi (1999) explained relevance of purchasing power parity theory taking
Bangladesh as a case. They used the co-integration technique to find out the long term
relationship among Bangladesh and World inflation rate and exchange rate. They tried to verify
whether relative PPP holds in Bangladesh case. They did not use any error correction model.
They found that relative PPP holds in case of Bangladesh, but only in the long term.
Ramasamy and Abar (2015) examined the effect of nine variables- relative interest rates, relative
inflation rate, relative balance of payments, relative employment rate, relative corruption index,
relative gross domestic product, relative deficit/surplus rate, relative tax rate, relative borrowing

Page |9

rate on the yearly exchange rate of three regions- Australian Dollar, Euro and US Dollar. They
used bootstrapping technique bolster the sample size. They examined multiple models and
finally found the best model where all variables other than relative GDP, employment rate and
deficit rate have significant effect on exchange rate.
Chowdhury and Hossain (2014) also used simple linear regression model to find out the effect
of Inflation rate, GDP growth rate, interest rate and current account balance on exchange rate.
Their study found that only GDP growth and current account balance has significant effect on
exchange rate.
Khan and Qayyum (2011) examines the role of variables representing monetary fundamentals for
Pakistani Rupee. They trie to find out the existance of cointegration between exchange rate,
inflation rate, gdp growth rate, interest rate and current account balance. They found that in the
long run the cointegrating coefficients are consistent with theory. The paper also discussed about
the short run behavior by applying persistence profiles approach.
Akther, Sarker and Saidjada (2013) looked into the fluctuation of exchange rate in Bangladesh
during 2004 to 2006 and 2010 to 2012. They used Structural Vector Autoregression (SVAR)
model to find out that both external demand shock and supply shocks are responsible for the
sharp depreciation. They also found out that money supply shocks had less effect than demand
shocks at that time.
Hopper (1997) examined in an article summarizing the empirical verification of various
exchange rate models and the factor of market sentiment in explaining the movement of
exchange rate. The evidence from the article suggests that the market fundamental models cannot
reliably forecast future exchange rate.
Rehman and Rehman (2002) tested the validity of purchasing power parity (PPP) for Pakistani
Rupee. They constructed a regression model with several macroeconomic variables and the
result from the regression analysis is consistent with the theory of PPP. They also used a form of
error-correction which suggested that nominal exchange rate has a role reducing deviations from
long run PPP.

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CHAPTER 3: METHODOLOGY

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3.1 POPULATION PARAMETERS

This research used quantitative research methodology. Quantitative research used data that are
structured in the form of numbers or that can be immediately transported in numbers (Ross,
1999). This research deals with time series data. A time series is a collection of observations of
well-defined data items obtained through repeated measurements over time. The population
consists of GDP growth, Current account balance, relative interest and exchange rate data from
1971 to present time.
3.2 SAMPLING DESIGN
All population data was no available to the researchers. Data is taken from 1976. So, researchers
have used the convenience sampling method. Convenience sampling is a non-probability
sampling technique where subjects are selected because of their convenient accessibility and
proximity to the researcher. The subjects are selected just because they are easiest to recruit for
the study and the researcher did not consider selecting subjects that are representative of the
entire population. So, this sampling can be the cause of systematic bias.
3.3 VARIABLES COVERED
The dependent variable is- Exchange rate (Local currency unit per dollar)
The explanatory variables are Relative interest rate (Bangladesh lending interest rate-United states lending interest rate)
GDP growth of Bangladesh
Current Account Balance of Bangladesh
Whereas,
Exchange Rate- Official exchange rate refers to the exchange rate determined by national
authorities or to the rate determined in the legally sanctioned exchange market. It is calculated as
an annual average based on monthly averages (local currency units relative to the U.S. dollar).
Lending Rate- Lending rate is the bank rate that usually meets the short- and medium-term
financing needs of the private sector. This rate is normally differentiated according to

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creditworthiness of borrowers and objectives of financing. The terms and conditions attached to
these rates differ by country, however, limiting their comparability.
GDP- GDP is the sum of gross value added by all resident producers in the economy plus any
product taxes and minus any subsidies not included in the value of the products. It is calculated
without making deductions for depreciation of fabricated assets or for depletion and degradation
of natural resources.
Current Account Balance-Current account balance is the sum of net exports of goods and
services, net primary income, and net secondary income.
3.4 METHODS OF DATA COLLECTION AND INSTRUMENTS USED IN DATA
COLLECTION
This study aimed to establish a relationship exchange rate and various macroeconomic variables
through an empirical research. The related data are collected mainly from secondary sources.
The data used in this study are compiled from World Bank Database for Bangladesh. Solely,
World Bank website is used for data collection.
3.5 DATA PROCESSING AND ANALYSIS/DATA ANALYSIS PLAN
The sample has been tested through descriptive statistics, correlation analysis and regression
analysis. After the compilation of data in an Excel sheet, Statistical software R is used to run
the regression analysis. First of all, is has been seen that whether correlation between the
explanatory variables are at the minimum level or not. Thats why correlation between the
explanatory variables are calculated and checked if any correlation is above 0.80.Then OLS
estimates, namely regression constant and regression coefficient, are calculated. Based on these
estimates a regression model is constructed in the following wayExchange rate= + 1*Relative interest rate + 2* GDP growth + 3* Current Account Balance
+ Ui

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CHAPTER 4
STUDY RESULTS AND FINDINGS

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4.0 STUDY RESULTS AND FINDINGS

We begin our findings section by the theoretical expectation of the relationship between the
dependent and explanatory variables. The quantitative analysis begins after the theoretical part.
4.1 THEORETICAL BACKGROUND
Exchange Rate is the number of domestic currency needed to obtain a foreign currency or vice
versa. Exchange rate is the price of foreign currency. Exchange rate can be quoted as a direct
quotation or an indirect quotation. When the number of local currency needed to obtain one unit
of foreign currency is expressed, the quotation is called a direct quotation. If the number of
foreign currency is needed to buy a unit of local currency is given, the quotation is called an
indirect quotation. Exchange of two foreign currencies is called cross exchange rate.
The exchange rate of Taka against the Dollar is increasing slowly over the years as shown below

50
20

30

40

LCU..

60

70

80

(local currency unit/dollar on the X axis and year in the Y axis)-

1980

1990

2000

2010

Year

4.1.1 Factors affecting exchange rate

Because exchange rate is a price, the demand and supply of currency determines the equilibrium
position of exchange rate at a time. This position is changed as demand and supply of exchange
rate are affected by various factors. Madura (2011) gave the following formula that summarizes
the effect of some major factors affecting exchange rate-

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e = f (INF; INT; INC; GC; EXP)

where, e = Percentage change in exchange (spot) rate
INF = change in the difference between domestic inflation and the foreign countrys inflation
INT = change in the difference between the domestic interest rate and the foreign countrys
interest rate
INC = change in the difference between the domestic income level and the foreign countrys
income level
GC = change in government controls
EXP = change in expectations of future exchange rates

Some other variables also affect exchange rate. For example, Low cost of production translates
into more export and the home currency faces upward pressure of currency. Investors avoid
country with high debt because it is related with inflation. Currency faces downward pressure.
While political stability improves investor confidence and results in appreciation of currency.
4.1.2 Relationship between Exchange Rate and GDP growth
Gross domestic Product (GDP) represents total output, total income and total expenditure in an
economy. Income also affects consumption and a part of the consumption is foreign products.
So, import increases and the domestic currency faces downward pressure. GDP also affects
interest rate and inflation, which in turn affect exchange rate. So, GDP also has an indirect affect
on exchange rate. So, the isolated affect of GDP growth may be negative on the exchange rate.
But the indirect affect can offset the relationship.
4.1.3 Relationship between Exchange Rate and Current Account Balance
Current account and capital account are two part of a countrys balance of payment. Current
account consists of trade balance, factor income and net cash transfers like remittance that
occurred within a specific time period. So, current account is one of the major parts in foreign
trade. A current account may be surplus or deficit, surplus current account means the country
gained more currency than it transacted away to other countries. A deficit is just the opposite.

P a g e | 16

A deficit in the current account means that the country is spending on foreign exports more than
it is earning, to make up for the deficit the country must borrow from the other countries. Now
the country needs more foreign currency than it can receive from the sale of export, and it must
supply more domestic currency than foreigners demand for its products to pay off the interest. As
a result, the domestic exchange rate falls. So the expected relationship between current account
balance and exchange rate is positive-a current account surplus should have positive effect on
exchange rate and a current account deficit should have negative effect on exchange rate.

4.1.4 Relationship between Exchange Rate and Relative Interest Rate

Interest rate affects the flow of foreign fund in a country. A high relative domestic interest rate
attracts foreign investment and a high relative foreign interest rate causes outflow of domestic
funds. High domestic interest rate increases the foreign investment and as foreign currencies
flow in the supply of currency is now higher. On the other hand, the supply of domestic currency
falls because domestic investors lose interest in foreign investment. The domestic currency
appreciates as a result. The theoretical expectation of the relationship between exchange rate and
interest rate is positive.
Interest rates, inflation and exchange rates are closely related variables. Central banks manipulate
the interest rate by monetary policy and changing the interest rate has consequences on the
inflation and exchange rate. High interest rate leads to appreciating currency but the effect is
mitigated by inflation. But the individual effect of high interest rate is an appreciating currency.

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4.2 CORRELATION ANALYSIS AND INTERPRETATION

The objective of correlation analysis is to measure the strength of linear association between two
variables (Gujarati, 2009). The correlation coefficient is the quantitative measure of this
correlation between variables. An assumption of the classical normal regression model is that
there is no exact collinearity between the X variables (Gujarati, 2009). The following correlation
matrix can be examined which lists the correlation between our explanatory variablesLCU..

GDP.growth

Current.Account

Relative.Interest

LCU..

1.0000000

0.5351711

0.7248981

0.6927587

GDP.growth

0.5351711

1.0000000

0.3907599

0.2392187

Current.Account

0.7248981

0.3907599

1.0000000

0.5637202

Relative.Interest

0.6927587

0.2392187

0.5637202

1.0000000

Table 1: Correlation Matrix

From the table, it can be observed that, none of the correlation coefficient between two
independent variables for the model crosses the value of 0.80 (High correlation). As a result, it is
mathematically safe to proceed with the regression analysis.

Relative.Interest

2e+09
1e+09

-5

0e+00
-1e+09

Current.Account

3e+09

10

The correlation between the variables is shown below with the help of graphs-

4
GDP.growth

4
GDP.growth

0
-5

Relative.Interest

10

P a g e | 18

-1e+09

0e+00

1e+09

2e+09

3e+09

Current.Account

Chart 1: Scatter plots of explanatory variables

As mentioned before, here LCU/$ is the exchange rate, which stands for local currency units
(Taka) per dollar. GDP growth indicates the nominal growth rate of GDP based on constant local
currency. Current Account represents current account balance in US dollar, which is the sum of
net export, net primary and net secondary income. As the correlation between the variable is not
high enough, the regression model is estimated next.

P a g e | 19

4.3 DESCRIPTIVE STATISTICS

The following table summarizes the descriptive statistics for the dataLCU..

GDP.growth

Current.Account

Relative.Interest

Min.

15.02

0.8191

-1.100e+09

-6.870

1st Qu.

29.80

3.8879

-4.258e+08

4.047

Median

41.04

5.0612

-2.550e+08

5.698

Mean

45.37

4.8862

1.983e+08

5.208

3rd Qu.

65.40

6.0136

5.656e+08

7.924

Max.

81.86

7.2339

3.556e+09

10.694

Table 2: Descriptive Analysis

From the descriptive analysis, the range, median, mean and 1st and 3rd quartiles are provided.
These descriptive statistics provides idea and overview of the data.

4.4 REGRESSION ANALYSIS AND INTERPRETATION

According to Gujarati (2009), Regression analysis is concerned with the study of the
dependence of one variable, the dependent variable, on one or more other variables, the
explanatory variables, with a view to estimating and/or predicting the (population) mean or
average value of the former in terms of the known or fixed (in repeated sampling) values of the
latter. Regression analysis is a useful tool to examine statistical relationship of variables where
exact prediction is often not possible and all variables cannot be identified.
The goal is to estimate the population regression function from the sample. The Population
regression function is given by,

Where, 1=Intercept and 2=Slope Coefficient.

From the sample data, the sample regression function is estimated which is given by,

P a g e | 20

Where,

= estimator of E(Y | Xi )

= estimator of 1
= estimator of 2
= estimator of 3
Generally, to estimate the parameters either MLE (maximum likelihood estimate) or OLS
(Ordinary least squares) is used. In this case the OLS estimates will be used and the estimates
will be calculated with the aid of statistical package R. First, we enter the data in spreadsheet
software and export it to comma delimited format. Then with the following command we can
find out the estimates for our regression model.
Data<-read.csv("D:\\last.csv",header=T)
Data
attach(Data)
lm1<-lm(LCU..~GDP.growth+Current.Account+Relative.Interest)
summary(lm1)
As mentioned before, our variables are LCU/$ (the exchange rate), nominal growth rate of GDP
of Bangladesh based on constant local currency, Relative interest rate between Bangladesh and
USA and the current account balance of Bangladesh in US dollar.

P a g e | 21

4.4.1 Output of Regression Analysis

The following output is obtained from the software R after giving data input and specifying
variable and our preferred model. The data is presented in APPENDIX 1.
Call:
lm(formula = LCU.. ~ GDP.growth + Current.Account + Relative.Interest)
Residuals:
Min
-28.070

1Q

Median

3Q

Max

-6.801

1.108

9.399

14.593

Coefficients:
Estimate

Std. Error

t value

Pr(>|t|)

(Intercept)

1.263e+01

7.337e+00

1.722

0.093722 .

GDP.growth

4.125e+00

1.386e+00

2.976

0.005195 **

Current.Account

7.462e-09

2.224e-09

3.356

0.001876 **

Relative.Interest

2.132e+00

5.633e-01

3.785

0.000562 ***

--Signif. codes: 0 *** 0.001 ** 0.01 * 0.05 . 0.1 1

Residual standard error: 11.7 on 36 degrees of freedom

Multiple R-squared: 0.7141,

Adjusted R-squared: 0.6903

F-statistic: 29.98 on 3 and 36 DF, p-value: 6.785e-10

4.4.2 Interpretation of Regression Analysis

The regression model explains 71.41% the variation of exchange rate as shown by the multiple R
squared and the adjusted R square of 69.03% shows that the model is moderately well
constructed.
The required parameter estimates are under coefficients heading. The estimates of intercept
(1) and slope coefficients (2, 3, 4) are given in scientific notation (exponential of 10). Using

P a g e | 22

a scientific calculator these numbers can be changed to normal, which gives us the following
parameter estimatesParameters

Estimate in Scientific Notation

Estimate in decimal notation

1.263e+01

12.63

4.125e+00

4.125

7.462e-09

0.000000007462

2.132e+00

2.132

The sample regression equation is,

Where, Yi= Average Exchange Rate (Taka/Dollar) at a specific time

X1= GDP growth rate of Bangladesh
X2= Current Account Balance of Bangladesh
X3= Interest Rate Differential between Bangladesh and USA
Here, we can find out that GDP growth has a positive relationship with Exchange rate, contrary
to our initial expectation. As we mentioned before, GDP has interrelation with many other
variables which may cause the theory of GDP depreciating currency a false.
On the other hand, the regression model shows that current account surplus positively affects the
exchange rate as explained by our theoretical description earlier. Also, high interest rate in
Bangladesh positively affects exchange rate in the regression model- which is also the expected
outcome from the priori expectation.

4.4.3 Significance Testing

The P value for the t-test is also calculated as part of the total output in R. The P value is the
probability of type 1 error (Gujarati, 2009), and type 1 error is the error of accepting a false
hypothesis. If the level of significance is 10%, that is allow up to 10% error- all parameters are
statistically significant as the P value<0.10 in all cases including the intercept.

P a g e | 23

Parameters

P Value

Significance

0.093722

Significant at 10% level

0.005195

Significant at 1% level

0.001876

Significant at 1% level

0.000562

Significant at .01% level

Table 2: Significance of the parameters

The overall P value is given 6.785e-10 (0.000000000678 in decimal notation) so the overall
model is also statistically significant.

4.5 ANOVA
ANOVA is an abbreviation for Analysis of variance. We can use ANOVA to calculate the FStatistics and test the significance of the model. The following ANOVA table was computed
with the help of statistical package R.

Analysis of Variance Table

Response: LCU..
Df

Sum Sq

Mean Sq

F value

Pr(>F)

GDP.growth

4936.0

4936.0

36.067

6.831e-07 ***

Current.Account

5410.9

5410.9

39.537

2.871e-07 ***

Relative.Interest

1960.4

1960.4

14.325

0.0005621 ***

Residuals

36

4926.9

136.9

--Signif. codes: 0 *** 0.001 ** 0.01 * 0.05 . 0.1 1

The P value is well below our level of significance 10% level. So we can conclude that the
differences between group means are statistically significant. So the model is found significant
from both significance tests.

P a g e | 24

4.6 SUMMARY OF FINDINGS

The key results from our theoretical and quantitative analysis are as follows Exchange Rates are expected to be affected by both economic factors and market
sentiment.
Interest Rate differentials, government factors, inflation differentials, income differentials
between countries are expected to affect the exchange rate. But the variables are
interconnected and the variables together have an uncertain affect on exchange rate.
GDP, a measure of economys total income, is expected to have a negative relationship
with exchange rate, as the rise in income leads to rise in demand for foreign goods and
which in turn, leads to higher imports.
Current account deficit means more imports and the subsequent borrowings come with
interest burden. As a result, current account surplus is expected to have positive effect on
the exchange rate.
High relative interest rate is also expected to positively affect the exchange rate as foreign
investment is made with foreign currency.
The correlation analysis showed that none of the explanatory variables are highly
correlated with each other.
The regression parameters were estimated by OLS method, and the following sample
regression function was arrived at:
The coefficient for GDP was positive contrary to the theoretical expectation, but all other
variable coefficient was positive and confirmed the priori expectation.
The significance for the variable and model was tested by t-test and f-test. The P values
computed from the tests were below the 10% level of significance selected for the study,
meaning the model and the estimated parameters were statistically significant.

P a g e | 25

CHAPTER 5: CONCLUSION AND RECOMMENDATION

P a g e | 26

5.1 CONCLUSION
Even many years after the emergence of modern economics, the behavior of exchange rate is still
a mystery. No model as of today can predict the movement of exchange rate. Many researchers
failed to establish the monetary model of exchange rate and the distance between theories found
in international finance textbooks and empirical evidence is not closing down.
In this study, the researchers attempted to explore the nature of the relationship between
exchange rate and selected macroeconomic factors, namely current account balance, relative
interest rate and GDP growth rate. In theory, the relationships between these variables are not
straightforward. While individual effect can be demonstrated keeping other things constant, the
practical effect of increase or decrease of a variable can be quite complex.
The regression model could explain 71.41% the variation of exchange rate as shown by the
multiple R squared. While the result is satisfactory for the purpose of this paper, better model
with more variables can be constructed for higher explanatory power of the model. The
coefficient for GDP was positive contrary to the theoretical expectation, but all other variable
coefficient was positive and confirmed the priori expectation.
Finally, the significance for the variable and model was tested by t-test and f-test. Both tests
showed that the estimates for the model are statistically significant.

5.2 RECOMMENDATIONS
On the basis of the results of this paper the following can be recommended First of all the research shows that exchange rate is systematically related to the economic
factors. While the factors are hard to estimate beforehand, the research on the relationship
between market fundamental and exchange rate should be carried on.
The relationship between interest rate and exchange rate was found in the research.
Because the interest rate can be controlled by the central bank, it should keep the
exchange rate at a good position and closely look at the tradeoffs and chain effects on this
relationship.

P a g e | 27

The GDP growth also had affect on the exchange rate, hence in the trend in the exchange
rate may be appreciating slowly. The government can offset this trend with appropriate
tools according to its policy.
The research used multiple linear regression model, more complex econometric
technique should be applied on the data in future to find out the internal relationship
among the variables.

P a g e | 28

APPENDIX 1
Data used in regression analysis is given below. All data collected from the World Bank
database. Here, LCU/$ represents Amount of Taka needed to buy 1 dollar, which is the exchange
rate. The other variables are GDP growth rate, Current Account Balance and Relative Interest
(Interest rate differential between Bangladesh and USA).
Year

LCU/$

GDP

Growth Current

Account Relative Interest

Rate

Balance

Rate

1976

15.39917

5.661361

-276313647.4

4.16

1977

15.3751

2.673056

-280958219.5

4.175833

1978

15.01612

7.073838

-383906631.1

1.943333

1979

15.55193

4.801635

-415947091.7

-1.66583

1980

15.45406

0.819142

-702138190.8

-3.9325

1981

17.98669

7.233944

-1016620063

-6.87

1982

22.11788

2.134328

-500670224.2

-2.86083

1983

24.61543

3.881046

-45800312.9

1.205833

1984

25.35393

4.80331

-477650344.9

-0.0425

1985

27.99459

3.342015

-455173414.8

2.066667

1986

30.4069

4.173383

-625181389.2

5.6675

1987

30.94983

3.772402

-237116009.3

7.796667

1988

31.73325

2.416257

-272836596.9

6.685

1989

32.27

2.836582

-1099566161

5.126667

1990

34.56881

5.622258

-397909576.6

5.990833

1991

36.59618

3.485228

64593233.33

7.453333

1992

38.95076

5.442686

180790960.4

8.748333

1993

39.56726

4.711562

359263637.7

1994

40.21174

3.890126

199568821.5

7.361667

1995

40.27832

5.121278

-823880196.6

5.170833

1996

41.79417

4.522919

-991418975

5.729167

1997

43.89212

4.489896

-286312953.2

5.558333

P a g e | 29

1998

46.90565

5.177027

-35165989.35

4.578333

1999

49.0854

4.670156

-364355314.2

5.105

2000

52.14167

5.293295

-305831650.6

3.521667

2001

55.80667

5.077288

-535424727.7

5.898333

2002

57.888

3.833124

739250272

7.934167

2003

58.15004

4.739567

131637632

7.92

2004

59.51266

5.239533

-278679383.7

6.059167

2005

64.32748

6.535945

507707732.4

4.425833

2006

68.93323

6.671868

1196063083

3.706667

2007

68.87488

7.058636

856792635

4.585

2008

68.59828

6.01379

926185438.6

7.801667

2009

69.03907

5.045125

3556126394

10.07667

2010

69.64929

5.571802

2108502537

8.969167

2011

74.1524

6.464384

-161842538.7

10.07167

2012

81.86266

6.521435

2575500681

10.69417

2013

78.10324

6.013596

2058473420

10.34333

2014

77.64141

6.061093

755790761.7

9.695

2015

77.94691

6.552633

2686936581

8.449167

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