Exchange Rate Modelling

226 Pages·1999·9.397 MB·English

by  Ronald MacDonald, Ian Marsh (auth.)

Exchange Rate Modelling
Advanced Studies in Theoretical and Applied Econometrics
Volume37
Managing Editor
J. Marquez, The Federal Reserve System, Washington, D.C., U.S.A.
Editorial Board:
F. G. Adams, University of Pennsylvania, Philadelphia, U.S.A.
P. Balestra, University of Geneva, Switzerland
M.G. Dagenais, University of Montreal, Canada
D. Kendrick, University of Texas, Austin, U.S.A.
J.H.P. Paelinck, Netherlands Economic Institute, Rotterdam, The Netherlands
R.S. Pindyck, Sloane School of Management, M.l. T., U.S.A.
H. Theil, University of Florida, Gainesville, U.S.A.
W. Welte, University of Lodz, Poland
The titles published in this series are listed at the end of this volume.
Exchange Rate
Modelling
by
Ronald MacDonald
University of Strathc/yde
and
lan Marsh
City University Business School
SPRINGER-SCIENCE+BUSINESS MEDIA, B.V.
Library of Congress Cataloging-in-Piblication Data
ISBN 978-1-4419-5113-7 ISBN 978-1-4757-2997-9 (eBook)
DOI 10.1007/978-1-4757-2997-9
Printed on acid-free paper
All Rights Reserved
© 1999 Springer Science+Business Media Dordrecht
Originally published byKiuwer Academic Publishers, Boston in 1999
Softcover reprint of the hardcover 1st edition 1999
No part of the material protected by this copyright notice may be reproduced or
utilized in any form or by any means, electronic or mechanical,
including photocopying, recording or by any information storage and
retrieval system, without written permission from the copyright owner.
Contents
page
List offigures ix
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
List of tables xi
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
1. INTRODUCTION 1
Plan ofthe book
101 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 2
Unaddressed issues
102 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 4
Themes of the book
1.3 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 5
2. SPOT AND FORWARD MARKET RELATIONSIDP 9
Forward rate unbiasedness
201 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 10
20101 Empirical tests off orward rate unbiasedness l1
0 0 0 0 0 0 0 0 0
20102 Rationalising the findings off orward rate bias 13
0 0 0 0 0 0 0 0
2010 3 Cointegration-based tests off orward rate bias 20
0 0 0 0 0 0 0 0
Rationality of expectations
202 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 22
Modelling the risk premium
2.3 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 31
20301 Latent variable models of the risk premium 33
0 0 0 0 0 0 0 0 0 0
2.302 ARCH models ofthe risk premium 34
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
20303 The portfolio balance-mean variance approach to risk 36
0
203.4 Miscellaneous risk models 38
0 0 0 0 0 0 0 0 0 0 0. 0 0 0 0 0 0 •• 0 0 • 0
Summary and conclusions
2.4 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 • 0 0 0 0 0 0 0 0 0 0 0 0 0 40
3. PURCHASING POWER PARITY: LONG AND SHORT RUN
TESTING 49
3 ol Purchasing power parity: traditional PPP versus the efficient
markets hypothesis
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 50
3.101 Testing traditional PPP against EMPPP using real
exchange rates 55
0 0 0 0 0 0 0 0 0 • 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 • 0 0 • 0 • 0
PPP and exchange rate forecasting
302 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 56
The power of unit root tests and the span of the data
303 0 0 0 0 0 0 0 0 0 59
30301 Increasing the span by increasing the time dimension . 60
0
303.2 Increasing the span by increasing the cross-section
dimension 60
0 0 • 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 • 0 0 0
Sticky prices versus the traded-non traded bias: A first pass at
3.4
Balassa-Samuelson 64
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
Does geography matter? A linear and non-linear perspective 66
305 0 0 0
30501 Transactions costs versus nominal exchange rate
volatility 66
0 • 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 •• 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 • 0
Vl
30502 Transactions costs and non-linear adjustment 0 0 00 00 0 0 68
3o6 Summary and conclusions 0 0 0 00 00 0 0 0 0 00 0 00 0 0 00 0 00 00 0 00 0 0 70
4. THE MONETARY APPROACH TO EXCHANGE RATE
MODELLING 79
4ol The flexible price monetary approach (FLMA) 0 0 00 00 00 00 00 0 81
40101 The magnification effect 00 0 0 00 00 0 0 00 0 00 0 00 0 00 0 0 0 0 82
401020 Speculative bubbles 0 0 00 0 00 0 0 00 0 0 00 00 00 0 00 0 00 0 0 0 0 83
402 The sticky price variant of the monetary approach (SPMA) 0 0 0 0 84
403 The hybrid monetary model, or RlD 0 00 00 0 00 0 00 00 00 00 00 00 0 88
4.4 Empirical evidence on the monetary model 0 00 0 00 00 0 00 0 0 0 0 0 90
4.401 Some monetary approach reduced forms 0 00 00 00 0 0 0 0 0 90
4.402 Early empirical evidence on monetary model 0 00 00 0 0 0 0 90
40403 Recent empirical evidence on the monetary model 00 0 0 0 92
405 Estimation and interpretation of the monetary model 00 0 00 0 0 0 0 96
40501 Money market equilibrium 00 0 0 00 0 00 0 00 0 00 0 00 00 0 0 0 0 96
40502 Foreign exchange market equilibria 00 0 00 00 0 0 00 0 0 0 0 100
405.3 Equilibrium in the gross system 0 00 00 0 00 0 00 0 00 00 0 0 0 102
405.4 An impulse response analysis ofd ynamic interactions 103
0
4o5o5 Forecasting and the random walk redux o0 00 0 00 00 0 0 0 105
406 Summary and conclusions 0 0 0 0 0 00 0 0 0 00 0 0 0 00 00 00 00 00 00 0 0 106
5. MODELLING DEPARTURES FROM PURCHASING
POWER PARITY 111
501 An eclectic exchange rate model 00 0 0 00 00 0 00 0 00 00 00 00 00 0 0 112
50101 The general price level channel and the demand
and supply for money 0 00 0 00 0 00 00 00 0 00 00 00 00 0 00 0 0 113
50102 The balance ofp ayments and the real exchange rate 114
0 0
5 02 An empirical application of the EERM 00 00 0 0 00 0 00 0 00 0 00 00 117
50201 The long-run relationship 0 00 00 0 0 00 00 00 00 0 00 00 00 0 118
50202 Impulse response functions 00 00 00 00 00 00 00 0 00 0 0 00 0 122
50203 Variance decompositions 00 0 0 00 00 0 00 0 00 00 0 00 00 0 0 0 125
5o3 Related research on real exchange rate modelling 00 00 00 0 0 0 0 128
5.301 A constant equilibrium exchange rate 0 00 0 00 0 00 00 0 0 0 128
5.3o2 Non-constant equilibrium -productivity and terms
oftrade 0 00 0 0 00 0 0 0 0 0 0 00 00 0 00 00 0 00 0 00 00 00 0 0 0 00 0 130
50303 Behavioural equilibrium exchange rates versus
fundamental equilibrium exchange rates 00 00 00 0 00 00 0 132
5.4 Structural VA R modelling ••.. 0. 00 0 . 0. . 0 00 . .. 0. 0. 0. 0. 0 0 134
5.5 Concluding comments ....... 0. 00 0 . 0. 0. 00 . 0. 00 0. 0. 0. 0 0 139
vii
6. IDGH FREQUENCY EXCHANGE RATE MODELLING 145
6.1 Cointegration and V AR modelling . . . . . . . . . . . . . . . . . . . . . . 147
6.1.1 Cointegrating relationships . . . . . . . . . . . . . . . . . . . . . . 148
6.1.2 Short-run dynamic relationships .................. 149
6.1.3 Empirical results: Cointegration and forecast
performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
6.1.4 Discussion ................................... 156
6.2 A univariate modelling technique . . . . . . . . . . . . . . . . . . . . . . . 156
6.2.1 Simple switching models ........................ 157
6.2.2 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161
6.2.3 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
6.3 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
7. LONG-RUN ECONOMETRIC MODELLING OF EXCHANGE
RATES 173
7.1 Systems modelling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
7.2 A small system for exchange rate modelling . . . . . . . . . . . . . . . 17 4
7.3 Bilateral exchange rate models . . . . . . . . . . . . . . . . . . . . . . . . . 179
7.3.1 Long-run relationships . . . . . . . . . . . . . . . . . . . . . . . . . 179
7.3.2 A parsimonious representation ................... 181
7.3.3 Beating a random walk and the creme de Ia creme of
forecasters: Some out-of-sample forecasting results . . . 184
7.4 A tri-polar system of exchange rates ..................... 188
7. 4.1 Long-run equilibria in the tri-polar system . . . . . . . . . . 190
7.4.2 Generalised impulse response analysis ............. 195
7.4.3 Forecasting accuracy .......................... 199
7.5 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
8. CONCLUSION 207
Index ofa uthors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
Index ofs ubjects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
lX
List of Figures
page
3.1 Real and Nominal Exchange Rates ................... 50
4.1 Phase Diagram Representation of SPMA ................... 87
4.2 Effects of a Decrease in the Money Supply ................. 88
4.3 Impulse Responses to a One Percent Shock to European
Money ...................................... 104
4.4 Impulse Responses to a One Percent Shock to US Money . . . . 1O S
5.1 Responses ofUS Nominal Effective Exchange Rate ......... 123
5.2 Responses of German Nominal Effective Exchange Rate ..... 124
5.3 Responses of Japanese Nominal Effective Exchange Rate .... 125
5.4 Real Effective Exchange Rate and Behavioural Effective
Exchange Rate for United States . . . . . . . . . . . . . . . . . 132
5.5 REER and Alternative BEER for US Based on Unchanged
Fiscal Deficit and Net Foreign Assets Post 1980 . . . . . 133
6.1 Daily Spot Exchange Rates - 1990-1996 . . . . . . . . . . . . . . . . . 14 7
6.2 Probability P 162
11 • • . • • • • • • • • • • • • • • • • . • • • • • • • • . • . • . • • • . •
6.3 Probability That Exchange Rate is in Regime 1 . . . . . . . . . . . . 164
6.4 Conditional Standard Deviation of Parsimonious Markov
Mode ....................................... 165
6.5 Conditional Standard Deviation of GARCH (1, 1) Model . . . . 167
7.1 Distribution of Relative RMSE- Professional Forecasters,
Three Month Horizon . . . . . . . . . . . . . . . . . . . . . . . . . . 186
7.2 Distribution of Relative RMSE-Professional Forecasters,
Twelve Month Horizon . . . . . . . . . . . . . . . . . . . . . . . . . 187
7.3 German Data ....................................... 188
7.4 Japanese Exchange and Interest Rate Data . . . . . . . . . . . . . . . . 189
7.5 Japanese Price Indices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190
7.6 Generalised Impulse Response to an (Historic) Innovation
in US Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
7. 7 Generalised Impulse Responses to an (Historic) Innovation
in US Interest Rates . . . . . . . . . . . . . . . . . . . . . . . .. . . . 198
7.8 Generalised Impulse Responses to an (Historic) Innovation
in German Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . 199
7.9 Generalised Impulse Responses of Error Correction Terms
to an (Historic) Innovation in German Interest Rates . . 200
7.10 Cointegrating Relationships - Time-Variation in Parameters . . 201
XI
List of Tables
page
2.1 Predicted and Unpredicted Changes in Exchange Rates,
1980-1994 .................................... 13
2.2 Tests of Forward Rate Bias .............................. 17
2.3 Individual Risk Premia and Rationality Tests . . . . . . . . . . . . . . . 18
2.4 Stationary Tests ...................................... 20
2.5 Tests of Survey Expectations Bias ........................ 23
2.6 Expectations Formation Mechanism-Consensus Measures .... 25
2.7 Individual Expectation Formation Mechanisms ............. 26
3.1 Engle-Granger Two Step Cointegration Tests ............... 52
3.2 Johansen Multivariate Cointegration Tests . . . . . . . . . . . . . . . . . 54
3.3 Dynamic Model Specification of British Pound-US Dollar
Model Using CPis .............................. 57
3.4 RMSE Statistic for Competing Models .................... 58
4.1 Coefficients ofVariation of Exchange Rates and Certain
Fundamentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
4.2 Summary of Coefficient Signs Implied by Different Monetary
Models ...................................... 89
4.3 MacDonald and Taylor Cointegration Results for the US
Dollar-German mark . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
4.4 MacDonald and Taylor Dynamic Forecast Error Statistics ..... 94
4.5 Misspecification Tests-Money Market Relationships . . . . . . . 96
4.6 Johansen Cointegration Test Statistics -Money Market
Relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
4.7 Restricted Cointegrating Vectors-Money Market
Relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
4.8 Adjustment Speeds - Money Market Relationships . . . . . . . . . . 99
4.9 Johansen Cointegration Test Statistics - Exchange Rate
Relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
4.10 Restricted Cointegrating Vectors - Exchange Rate
Relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
4.11 Cointegration Tests of Gross System . . . . . . . . . . . . . . . . . . . . 102
4.12 Root Mean Square Error Ratios . . . . . . . . . . . . . . . . . . . . . . . . . 106
5.1 Multivariate Johansen Cointegration Results for the EERM . . 120
5 .2 Restricted Co integrating Vectors . . . . . . . . . . . . . . . . . . . . . . . . 121
5.3 Variance Decomposition of the Three Eclectic Exchange
Rate Models ................................. 127
6.1 Tests ofCointegration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
6.2 Root Mean Square Error Performance . . . . . . . . . . . . . . . . . . . 153