How important are the international financial market imperfections for the foreign exchange rate dynamics: A study of the sterling exchange rate. (June 2019)

• Record Type: Journal Article
• Authors: Dong, Xue; Minford, Patrick; Meenagh, David
• Is Part Of: Journal of international money and finance. Volume 94(2019)
• Page Start: 62
• Page End: 80
• Publication Date: 2019-06
• Subjects: E63 -- F31 -- F34 -- F41 -- F47; Small open economy DSGE model -- International financial imperfections -- Sterling exchange rates -- Indirect Inference -- Crisis -- Policy rules; International finance -- Periodicals; Foreign exchange -- Periodicals; Finances internationales -- Périodiques; Change -- Périodiques; Foreign exchange; International finance; Periodicals; 332.04205
• DOI: 10.1016/j.jimonfin.2019.02.012
• Languages: English
• ISSNs: 0261-5606

Abstract

Highlights: International financial imperfections are important in explaining the sterling movement. Indirect Inference tests show that our model fits the UK data behaviour between 1975 and 2016. Financial market imperfections act as an amplifier of external shocks on the sterling. Financial shock explains sharp sterling depreciation at the end of 2008 and after the Brexit vote. Abstract: The UK has been a net debtor over the past two decades and the sterling exchange rates are sensitive to any chaos that might occur in the financial market. This paper examines the importance of the international financial imperfections in the sterling exchange rate dynamics. We build a small open economy DSGE model with the constrained international financial institutions that intermediate capital flows, and derive tractable analytical solutions. The constraint works to introduce a wedge between lending and borrowing rates, which compensates financiers for their currency risk-taking. The model has been estimated by using a simulation-based Indirect Inference approach, which provides a natural framework for testing the hypothesis implied by the model. We find that the model cannot be rejected by the UK data. Shocks to financial forces are the main driving forces behind the large and sudden depreciation of the Sterling exchange rates in the aftermath of the collapse of Lehman Brothers and the Brexit vote. Furthermore, the optimal policy rules have been proposed.