Exchange rate determinations - A multiple linear regression analysis on the correlation between exchange rate, interest rate and inflation rate

Abstract

The exchange rate market is a financial market with very high volatility and unpredictability. Even though there does exist some key economic theories on what influences the exchange rate market, the high volatility makes predictions as hard as for any other financial market. Inflation, interest rate, current account deficits, public debt, terms of trade, economic performance and future expectations are seven main factors that affect the exchange rate. Interest rate and inflation are the two known key variables that affect exchange rate fluctuations, but the correlation between the two variables and the exchange rate is uncertain. Thus, these two variables will be further examined in this report. The aim of this report is to provide further understanding to the strength of a correlation between exchange rate, interest rates and inflation rates in Sweden, and investigate the effects on the correlation by a global financial crisis. In order to investigate the correlation, a multiple linear regression analysis was conducted, by putting the exchange rate as the dependent variable and putting inflation rate and interest rate as the independent variables. The data used in the multiple linear regression analysis are all in percentage points and the sample size contains 120 different values since the time period was 10 years, with one value from each month. Furthermore, a second multiple linear regression was conducted with annual data, which resulted in a sample size of 10 values. This was done in order to investigate the significance of a large sample size, and to investigate the sticky-price theory. There is a strong correlation between exchange rates and inflation rate/interest rate and the strength is affected by the global financial crisis.