Path analysis of exchange rate movement

Abstract

Governments and businesses are increasingly aware of the effects that exchange rate movements can have on the economic state of the country and the profitability of businesses. A need to better predict exchange rate movements is in demand. By using structural path analysis, this study developed a prediction model of the exchange rate movement. Using data of the Japanese and US economies from 1973 to 2017, this study found that percentage change in GDP differential, the percentage change in the log of M2 differential, real interest rate differential, and inflation rate differential to be determinants of exchange rate movements between the two countries. Furthermore, the resulting structural path model was able to explain 91% of the variation in the JPY/USD exchange rate movements.