Working with Professor Islamaj in the Economics Department this summer involved researching the effects of financial integration (i.e., depth of linkage with international financial markets) on currency exchange rate depreciation.  After reviewing relevant microeconomic and macroeconomic literature, we explored the effect of exchange rate depreciations on consumption, investment, and prices in various countries.  Gathering country financial account and economic growth data from the International Monetary Fund (IMF) and other databases, we used STATA, a data analysis and statistical software program, to write “do files” (lists of STATA commands and operations) and to perform regressions measuring key variables’ contributions to pass-through from exchange rate depreciations to prices.

This project is among the first to investigate the explicit effects of financial globalization on the transmission of exchange rate shocks  (i.e., events causing at least a 15% increase in the exchange rate) to prices within the affected country. Some factors that could trigger an exchange rate shock include major environmental disasters, unsustainable increases in national debt, global confidence crises, and wars  Our goal is to describe how a country’s lending or borrowing affects the relationship between such exchange rate shocks and prices.

We are distinguishing between net lender and net borrower countries to show the difference in investment behavior between two groups of countries (net creditor and net borrower nations) as a result of exchange rate depreciation. We hypothesize that exchange rate depreciation will negatively affect investment of net borrower countries relative to net lender countries, resulting in higher prices in net lender countries. Using 2SLS Arellano (2003) regressions for dynamic panels with lagged dependent variables and exogenous variables in a large T setting, our preliminary results (see table below) support our hypothesis. Most notably, net lender countries have a significantly larger inflation coefficient than net borrower countries.