A migration based theory of the exchange rate and the New Zealand’s experience

Abstract

Conventional exchange rate theory has proven unreliable in its attempts to explain the real exchange rate. In the March 2003 Reserve Bank Monetary Policy Statement two graphs appeared, one of total net migration and the other the nominal TWI exchange rate. Closer inspection revealed they were correlated. This paper aims to answer the question: can migration be used to predict the exchange rate? The hypothesis tested in this paper is that the heterogeneity in the market shares of aggregate demand and labor supply between the migrants and the native-born population constitute important determinants of the real exchange rate. In particular, the model provides an analytically tractable equation consistent with a general equilibrium theory of the exchange rate determination as a function of migration. It turns out that migration data is able to partially explain the movements in the real exchange rate. The correctly specified general equilibrium performs well in and out of the sample and gives valuable insight into the determination of the real exchange rate for New Zealand.