Third Country Effect on Exchange Rate: A Theoretical Explanation

This paper presents a theoretical model to explain the third country effect on bilateral exchange rate. The conventional trade theories suggest that the bilateral exchange rate in a free-floating regime is determined by the demand and supply of the two currencies concerned. It implies that all the credit items in the balance of payment forming the supply side and all the debit items in the balance of payment forming the demand side would determine the bilateral equilibrium exchange rate. The traditional two country trade models are based on the implied assumption that the key variables such as exports, imports, FDIs, and net transfers between the two countries are key determinants of the foreign exchange rate between the two currencies concerned.

This paper extends the traditional two country model into a three-country model and logically shows the possibility of variables pertaining to a third country to influence the bilateral exchange rate of the two countries concerned, which is known as the "third country effect".  The "third country effect" is not a novel concept in trade literature. It has been empirically tested by many researchers on several grounds such as the third country effect on trade, the third country effect on the domestic interest rate, the third country effect on the domestic price level etc. Although almost all such studies more or less have justified empirical evidence supporting the existence of the third country effect, the transmission mechanism of the third country shocks is still not clear. This paper develops a theoretical model to demonstrate how the third country effect is transmitted to the bilateral exchange rate. This paper bridges a long-standing gap in theory and literature.