Short-run Lats Rate Movements: Impact of Foreign Currency Shocks via Trade and Financial Markets

This paper investigates the short-run dynamic impact of foreign currency shocks on the deviations of Latvian <i>lats</i> vis-à-vis US <i>dollar</i> market spot rate from the parity set via <i>lats'</i> peg to SDR for the period from 1994 to 2000. The analysis is based on the standard theoretical model of dynamic cost adjustment, from which empirical models of the autoregressive distributed-lags form are derived. Reduction of several versions of such general models leads to a number of parsimonious and data congruent models. Our main findings from the modelling experiment are: Cross-currency shocks produce extensive impact on the net rate of <i>lats</i>, especially those shocks from the neighbouring transition economies, such as Estonia and Lithuania; These shocks may not be original, and may well act as transmission ports of other foreign currency shocks; The Russian crisis of August 1998 has exerted massive devaluation pressure on <i>lats</i>; The shocks are found to be transmittable via either trade and financial linkages, with the financial channel being the most contagious; Model configurations are found, however, neither unique nor definitely invariant, suggesting that it might be necessary to maintain several models in practice to fulfil different purposes in policy analyses and economic forecasting.