Exchange Rate Developments and Stock Market Dynamics in Transition Countries: Theory and Empirical Analysis

We present new theoretical approaches to exchange rate determination and stock market price dynamics as well as first empirical results for selected transition countries. The exchange rate is considered as reflecting both the interest parity - with a specific formulation for exchange rate expectations - and impulses from purchasing power parity which in turn is related to a modified monetary approach to exchange rate determination; the modification concerns the role of stock market prices in the demand for money. Our main focus is on the nominal exchange rate. The empirical results for the dollar exchange rate presented, based on quarterly data, are two-stage and three-stage least squares estimations. The three stage estimation reflects - which is a superior approach to the two-stage estimates in terms of exploiting the information in the data of the sample - the theoretical basis, namely that exchange rate dynamics and stock market prices are interdependent. The estimations for Hungary, the Czech Republic and Poland show significant coefficients for the lagged exchange rate, the stock market price and US GDP as well as other variables which are significant only in some of the countries considered. The in-sample forecast is excellent for all three countries so that anticipation of future exchange rate changes seems to be possible: this is not only relevant for economic actors but also for the issue of Euro area membership. Moreover, the considerable impact of stock market prices on the nominal exchange rate suggest that problems of stock market bubbles in the US might strongly contribute to unstable exchange rates in Europe.