An analysis of the correlation between foreign currency reserves and the exchange rate : an empirical study of Malta

Abstract

The purpose of this dissertation is to conduct an empirical analysis of the relationship between foreign currency reserves and the exchange rate in the Maltese context. This dissertation will utilise the knowledge from previous academic literature, where the important findings have been highlighted in Chapter 2. It will then analyse the relationship of the foreign currency reserves and the exchange rate quantitatively whilst looking at other important variables, i.e. GDP growth and the domestic money supply. Furthermore, this dissertation highlights the limitations faced while conducting research and suggests ways to overcome these limitations in future studies. An econometric model has been formulated to conduct this study, and a series of quantitative tests are conducted, including the Johnson cointegration test and the Granger Causality test. This dissertation went a step further from similar studies and analysed the impulse response function and the variance decomposition. After conducting a series of rigorous tests and analysis, it can be concluded that Malta’s foreign currency reserves are not essentially exhibiting a short-run causal relationship nor a significant long-run association with the exchange rate in the case of the Maltese economy.