A NOTE ON FORECASTING EXCHANGE RATES USING A CLUSTER TECHNIQUE

CHAPTER ONE

INTRODUCTION

1.1 Background Information

The exchange rate is the rate at which one currency is exchanged for another. It is the price of one currency in terms of another currency ( Jhingan, 2005). Exchange rate is the price of one unit of the foreign currency in terms of the domestic currency. The debate over what determines the choice of exchange rate regimes has continued unabated over some decades now. Friedman (1953) argued that in the presence of sticky prices, floating rates would provide better insulation from foreign shocks by allowing relative prices to adjust faster. His popular support for floating exchange rate stipulates that in the long run the exchange rate system does not have significant real consequences. His reasoning is that the exchange rate system is ultimately a choice of monetary regimes. In the end, monetary policy does not matter for real quantities, but in the short run it does. While Mundell’s (1963) posits that in a world of capital mobility, optimal choice of exchange rate regime should depend on the type of shocks hitting an economy: real shocks would call for a floating exchange rate, whereas monetary shocks would call for a fixed exchange rate. 

Traditionally, it has been argued that a country’s optimal real exchange rate is determined by some key macroeconomic variables and that the long-run value of the optimal real exchange rate is determined by suitable (permanent) values of these macroeconomic variables (Williamson, 1994). Incidentally, since the fall of Bretton-Woods system in 1970s and the subsequent introduction of floating exchange rates, the exchange rates have in some cases become extremely volatile without any corresponding link to changes in the macroeconomic fundamentals. This however has led to higher interest in exchange rate modeling as the question of exchange rate determination reveals to be one of the most important problems on theoretical field of monetary macroeconomics.

There are different types of exchange rate regimes practiced all over the world; from the extreme case of fixed exchange rate system to a freely floating regime. Practically, countries tend to adopt a combination of different regimes such as adjustable peg, crawling peg, target zone/crawling bands, and managed float, whichever that suits their peculiar economic conditions. For instance, exchange rate managements in Nigeria has witness different significant changes over the past four decades. Nigeria maintained fixed exchange rates from 1960 till the breakdown of the Bretton Woods Monetary System in the early 1970s. Between 1970 and mid 1980 Nigeria exchange rate policy shifted from fixed exchange rate to a pegged arrangement and finally, to the various types of the floating regime since 1986 following the adoption of the Structural Adjustment Programme (SAP) (see Sanusi, 2004).