Modern Economy, 2012, 3, 518-521
http://dx.doi.org/10.4236/me.2012.35067 Published Online September 2012 (http://www.SciRP.org/journal/me)
Exchange Rate Determination in Developing Economies
Oluremi Davies Ogun
Department of Economics, University of Ibadan, Ibadan, Nigeria
Received July 19, 2012; revised August 17, 2012; accepted August 25, 2012
ABSTRACT
This paper identifies the determinants of nominal exchange rate movements in less developed countries operating the
flexible exchange rate system. Factors peculiar to such countries which are believed to potently drive their nominal ex-
change rates are incorporated into the resulting model. In particular, the weather, parallel market exchange rate and its
associated premium as well as corrupt practices enter the model. While all four factors should play crucial roles in ex-
plaining short-run variations in the exchange rate, corrupt practices may still be at work in the long-run. However, those
more advanced developing countries that have succeeded in instituting a relatively more effective legal system stem-
ming the tide of corruption, and, also characterized by a near absence of parallel exchange rate market, may follow the
standard model of exchange rate in the literature.
Keywords: Purchasing Power Parity; Parallel Market Exchange Rate; Parallel Market Exchange Rate Premium;
Corruption
1. Introduction
Either on its own or in terms of its linkage with the real
exchange rate (RER), the nominal exchange rate repre-
sents a powerful economic policy tool as it influences
resource allocation, growth of international trade and struc-
tural change. For a market economy, it is about the most
important relative price influencing practically all other
prices. Thus, it deserves utmost attention especially, in
matters of determination.
The theoretical literature on the determination of nomi-
nal exchange rate recognizes the influence of international
trade and payments, speculation and hedging activities.
Due however to the peculiar circumstance of most de-
veloping countries (being mostly agrarian and with a lax
legal system for examples), some factors that enter into
their exchange rate determination processes may be dis-
tinct. The aim in this paper is to highlight such subtle
distinctions. Section 2 below provides a brief review of
the theoretical literature while Section 3 deals with the
rate determination model. Section 4 gives some conclud-
ing remarks.
2. Related Literature
Four approaches to nominal exchange rate determination
are prominent in the literature (see e.g. Isard [1], Mac-
Donald and Taylor [2], Taylor [3]). They are the tradi-
tional model, the monetary model, the portfolio balance
approach and the purchasing power parity model. The mod-
els are briefly discussed below only in the context of
flexible exchange rate system.
In the traditional model, forces of supply of, and de-
mand for foreign exchange play crucial roles in the de-
termination of the equilibrium rate which emerges at the
equality of the supply of and the demand for foreign ex-
change. Capital flows perform important function in main-
taining equilibrium in this model with an outflow moder-
ating current account surplus and an inflow easing (finance-
ing) current account deficit. In order to prevent excessive
changes in the exchange under this approach, attention is
usually paid to the determinants of the changes in the
current account which are, relative prices and income.
Accordingly, a situation of current account deficit which
tends to depreciate the exchange rate calls for concerted
effort at reducing both domestic price level and income
while raising interest rate. However, the seeming over-con-
cern with policy actions to induce capital flows to finance
disequilibrium carries with it the implication of a passive
assumption that the asset market simply follows the pol-
icy dictates of the deficit country. Quite clearly, independ-
ent actions from foreign bond holders could throw a mon-
key wrench in the works.
The monetary model is similar to the traditional model
in the sense of relying on market forces albeit in the money
market to determine the equilibrium exchange rate. Un-
der this setting, the exchange rate adjusts to accommo-
date any disequilibrating development in the money mar-
ket. For example, monetary expansion which could pro-
duce an excess supply of money would also cause price
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O. D. OGUN 519
level to rise leading to exchange rate depreciation. How-
ever, the level of wealth also increases causing the pur-
chase of financial assets (including, foreign assets) to rise
which in turn generates an increase in the demand for
money. Ultimately, the excess supply of money would be
mopped up and the exchange rate returns to its original
level in the long-run (see e.g. Frenkel [4], Frenkel and
Mussa [5] and Machlup [6]). Thus, given flexible ex-
change rate system, any disequilibrium in the money
market is short-lived and the exchange rate only changes
temporarily to accommodate this development otherwise,
balance of payments deficit would result. Pressure for
such (self reversing) short-run movements in the exchange
rate could also come from changes in interest rate and
income. The only drawback to this approach is that it
assumes unrealistically that the domestic and foreign
financial assets are perfect substitutes; this may be a
source of persistent disequilibrium under the model.
The Portfolio Balance approach views the exchange
rate as resulting from a process of financial equilibrium
in the economy. Such financial equilibrium results from a
simultaneous equilibrium in the individual financial asset
markets, that is, when the amount of each asset desired to
be held is the amount that is actually held. Three of such
markets are considered crucial here, domestic money or
monetary base, domestic bonds and foreign bonds. Three
equilibrium prices emerge from the attainment of this
financial equilibrium: equilibrium price of each asset, the
equilibrium interest rate in the country and the equilib-
rium exchange rate. The exchange rate emerges from this
model because any portfolio switches between the do-
mestic assets and the foreign asset necessitates new de-
mand for foreign exchange (Appleyard et al. [7]). How-
ever, it has been noted that the approach disregards the
fundamentals of trade in its calculations (Ojo [8]) and,
this may be a source of inexplicable changes in the ex-
change rate.
The Purchasing Power Parity (PPP) doctrine seeks to
identify the true equilibrium rate that would ensure si-
multaneous attainment of current and capital account bal-
ances. It exists in two versions, an absolute version and a
relative version. In a general context, the PPP postulates
that the price of any given commodity remains the same
in all countries when measured in the same currency. It is
therefore sometimes referred to as the law of one price
(LOOP) under which arbitrage plays an important role in
effecting the price parity across geographical locations.
Notwithstanding the infraction to this law often engen-
dered by transportation and handling charges, it is gener-
ally believed that the law is plausible. Accordingly, the
absolute PPP stipulates that the absolute level of the ex-
change rate is that which causes traded goods and ser-
vices to have the same price in all countries when meas-
ured in the same currency. There is however very little
empirical support for the absolute PPP due to the rather
strong influence of transportation costs and trade barriers
at keeping prices from equalising across geographical
locations, and the effect of the differences in the compo-
sition and relative importance of various goods on each
country’s price level determination (Appleyard et al. [7],
Rogoff [9]). As a result, the relative PPP is often resorted
to for operational concept. Under this version, the equi-
librium rate equals an initial period (base year) exchange
rate multiplied by the ratio of the price indices of the
domestic and foreign countries. In this way, the relative
PPP only captures an implicit rate, the real exchange rate,
and it is thus not particularly useful in the analysis of the
movements in the explicit rate, the nominal exchange rate.
3. The Model
This model describes the determination of the nominal ex-
change rate in a developing country operating the flexible
exchange rate system. The nominal exchange rate (NER) is
the price of foreign currency in units of domestic cur-
rency. It is assumed to be determined in the same way as
the prices of commodities that is, by the forces of the
market albeit, in the foreign exchange market. Thus, there
is a demand component, a supply component and an equi-
librium segment.
Broadly, the demand for foreign exchange (D) is in-
fluenced by three factors: changes in the level of imports
(M), capital outflow in the form of transfer payments,
grants and loans, overseas investments (Co) and specula-
tion (Sp)1. Thus,


DDM,Co,Sp (1)
Changes in the level of imports would be a function of
changes in domestic price level (π), and income (Y). Capi-
tal outflow would be influenced by the quest for overseas
investment by governments and residents and this quest
would be a function of foreign income (Y*) and relative
inflation rates (π – π*) as well as capital flight. Capital
flight can be simply expressed as a function of interest
rate differential (i – i*) and socio-economic instability
that can be represented by fiscal deficit (FD) and corrupt-
tion (C) which in turn can be proxy by corruption per-
ception index. Under a dual exchange rate system, the
parallel market exchange rate premium (PMP) would
also qualify as a proxy for corruption. Speculation can be
narrowed to the existence of parallel market exchange
rate (PMR) or its premium (PMP), so that we write2,
2Since by assumption, the model relates to an economy operating the
flexible exchange rate system, speculative activities of the type of leads
and lags are minimal in the absence of any expected major currency
realignment policy as could happen under a fixed exchange rate system
and its variants.
1The influence of hedging in the domestic economy is in this model sub-
sumed under speculation.

O. D. OGUN
520

***
DDπ,Y,Y ,ππ,ii, FD,C, PMR, PMP (2)
with all partials expected to be positive.
On the other hand, the supply of foreign exchange (S)
will be a function of changes in exports (X), foreign in-
vestments (FI), changes in foreign reserves (R) as well
as speculation and hedging activities of foreigners (Sh)
such that we can write,

SX,Fi,R,Sh


(3)
Changes in export will be a reflection of the interna-
tional price of export items and weather condition
in the domestic economy which can be proxy by a trend
variable (TT) reflecting the difference between actual and
trend real agricultural output. Foreign investment would
be influenced by general reform climate which can sim-
ply be represented by the real exchange rate (RER). Chan-
ges in foreign reserves would be a result of changes in
the balances on both current and capital accounts which
are in turn influenced by price level changes, income, in-
ternational price of exports, weather conditions and inter-
est rate differentials. Speculation and hedging activities
of foreigners would be influenced by parallel market ex-
change rate (PMR), inflation differentials (π – π*), inter-
est rate differentials (i – i*) and the size of the stock
market represented by its market capitalization (MK).
Thus, we have that,

E
T
P

E**
T
SSπ,Y,P,TT,ππ,ii ,MK,RER,PMR (4)
Except for π – π* and PMR, all partials are expected to
be positive.
Incorporating income differential to track the effect of
long-run capital flows, equilibrium NER equation would
result from the net of Equations (2) and (4) such that,


**E
T
3
EEππ, Y,YY, P,TT,ii,
FD,C,MK, RER,PMR,PMP
*

 
(5)
Apart from inflation differential (π – π*), fiscal deficit
(FD), parallel market exchange rate (PMP) and the paral-
lel market exchange rate premium (PMP) whose changes
would produce a depreciating effect on the exchange rate,
all other variables’ partials are expected to be positive4.
Four variables, TT (trend variable capturing the influ-
ence of weather condition), C (corruption), PMR (paral-
lel market exchange rate) and PMP (parallel market ex-
change rate premium) appear to be peculiar to the typical
developing economy. Corruption exists in almost all coun-
tries of the world but the nature and manner of occur-
rence of the vice in developing countries are such that, it
generates serious adverse consequences for the growth of
such economies in the short-run (see e.g. Asiedu and
Freeman [11], Anorou and Braha [12]) and the long-run
too (see e.g. Dissou and Yakautsava [13] and Ogun [14]).
To escape detection and legal or political restitution of
the looted treasury funds, such funds often take on the na-
ture of capital flight. Thus, unlike in most advanced coun-
tries, such looted funds hardly contribute meaningfully to
economic activities in the typical developing country5.
Furthermore, in the course of their flight, the looted
funds often produce new distortions or reinforce existing
distortions especially, in relative prices, in the economy.
In most cases, the parallel exchange rate market is patron-
ized with the associated rate rising significantly, thereby,
putting upward pressure on the related parallel market
premium as the main market exchange rate (and the in-
ter-bank rate too) depreciates. It was reported in Ogun
[15] that the explosion in commodity prices witnessed in
the late 1980s (the early years of the switch from fixed to
flexible exchange rate system) in Nigeria was due to the
incidence of capital flight. The parallel market rate and
premium were also joint beneficiaries6.
3The marked difference in the definitions of the parallel market exchange
rate and the parallel market exchange rate premium, should reduce the
p
ossibility of multicollinearity from their joint presence in the equation.
The premium could for example be defined as the percentage excess of the
p
arallel market rate over the official rate (see e.g. Dornbusch et al. [10]).
4Foreign income does not enter the equilibrium equation independently
because the motives for its entry are already captured by interest rate
differentials and stock market capitalization. Where there is a compel-
ling urge to include foreign income in Equation (5) as part of the de-
mand drivers for export hence, source of supply of foreign exchange,
the nature of exported items (that is, whether they are luxuries or ne-
cessities to the importer country) should be considered instead.
5There are other forms of corrupt practices which though do not end up
in capital flight also exert appreciating influence on the exchange rate
through the related parallel market rate and premium. An example is
the well-known practice of round-tripping by banks under which they
bid for and purchase foreign exchange at the auction (autonomous mar-
ket’s) rate but end up selling at the parallel market at that market’s rate.
Government agencies are sometimes accomplices in this act as they spe-
cially arrange for sizable government funds to be placed on deposits
with these banks and thus increase the banks’ and the agencies’ profit
from such round-tripping business. Overall, the reduced supply inthe
conventional market raises the inter-bank rate and the autonomous mar-
ket’s rate both of which could put upward pressure on the official rate;
the bureaux de change and the parallel market rates similarly benefit from
the increase in the patronage of the related markets.
In general, while the effects of PMR, PMP and the
weather on nominal exchange rate should be expected to
wear off in the long-run7, that of corruption may still be
active in the same run8. However, some of the more ad-
vanced developing countries may be spared the influence
of these additional variables. Usually, such countries are
not capital (including, foreign exchange) scarce, hence,
the incentive for a thriving parallel exchange rate market
6Incidences of leads and lags hedging practice may have been contributory
to the emergent exchange rates but were in this particular instance, indis-
tinguishable from the broad play of capital flight.
7Prolonged adverse weather condition would usually elicit policy resp-
onse to mitigate its macroeconomic effects.
8Two variables in the standard model, inflation differential and income
or real income (or its growth)—the latter as a proxy for productivity
growth, could similarly exert long-run effect. Other long-run factors
though not written into the model include, taste (that is, preference for
domestic or foreign goods) and, tariffs and quotas. For further details
onthese additional long-run determinants, see for example, Mishkin [16].

O. D. OGUN
521
is almost non-existent. In addition, they have mostly suc-
ceeded in instituting a relatively effective legal system
helping to stem the tide of corrupt practices. Thus, such
economies are more likely to be accurately represented
by the standard exchange rate determination model in the
literature.
4. Conclusion
Existing models of nominal exchange rate determination
in the literature mostly ignores the peculiar developments
in developing countries and therefore inaccurately de-
scribes the modalities of short run movements in these
countries’ nominal exchange rate. This paper rectified this
oversight by developing a model which accommodates
those crucial but unconventional determinants of the nomi-
nal exchange rate in the typical developing economy. Fac-
tors such as weather condition, the existence of parallel
market exchange rate, its associated premium and corrupt
practices are identified to be critical drivers of short term
variations in the nominal exchange rate. Even, in the
long-run, a factor such as corruption could still be play-
ing very important roles. It should however be under-
stood that only particular types of developing countries’
exchange rate dynamics would be explained by this model.
Some advanced developing countries may have developed
a more effective legal system curtailing corrupt practices.
Such countries’ exchange rate system may also be devoid
of the sharp parallel market practices bestriding the less
advanced developing countries’ exchange rate system. In
this case, the standard modelling approach noted in the
introductory section would be more applicable.
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