International Parity Conditions: Theory, Econometric Testing and Empirical Evidence PDF
Preview International Parity Conditions: Theory, Econometric Testing and Empirical Evidence
INTERNATIONAL PARITY CONDITIONS International Parity Conditions Theory, Econometric Testing and Empirical Evidence Imad A. Moosa Senior Lecturer in Economics La Trobe University Australia and Razzaque H. Bhatti Assistant Professor of Economics University ofA zad Jammu and Kashmir Pakistan First published in Great Britain 1997 by MACMILLAN PRESS LTD HoundmilIs, Basingstoke, Hampshire RG21 6XS and London Companies and representatives throughout the world A catalogue record for this book is available from the British Library. ISBN 978-1-349-25525-2 ISBN 978-1-349-25523-8 (eBook) DOI 10.1007/978-1-349-25523-8 First published in the United States of America 1997 by ST. MARTIN'S PRESS, INC., Scholarly and Reference Division, 175 Fifth Avenue, New York, N.Y. 10010 ISBN 978-0-312-17262-6 Library of Congress Cataloging-in-Publication Data Moosa, Imad A. International parity conditions: theory, econometric testing and empirical evidence / Imad A. Moosa and Razzaque H. Bhatti. p. cm. Includes bibliographical references and index. ISBN 978-0-312-17262-6 I. Foreign exchange-Mathematical models. 2. Purchasing power parity-Mathematical models. 3. Interest-Mathematical models. 4. International economic relations-Mathematical models. I. Bhatti, Razzaque H., 1956- . II. Title. HG3823.M664 1997 332.4'5-dc21 96-44007 CIP © Imad A. Moosa and Razzaque H. Bhatti 1997 Softcover reprint of the hardcover 1s t edition 1997 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London WI P 9HE. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. 10 9 8 7 6 5 4 3 2 I 06 05 04 03 02 01 00 99 98 97 To our Families Contents List of Figures xii List of Tables xiv Preface xv 1 Introduction 1 An Overview The Resurgence of Interest in International ~~~ili~M 4 A Look at the Figures 5 What Follows in this Book 14 2 The Purchasing Power Parity Hypothesis 25 Introduction 25 Absolute and Relative PPP 27 PPP in the History of Economic Thought 30 The Arbitrage. Monetary and Asset Market Views of PPP 32 Ex Ante PPP 36 The Productivity Bias Hypothesis 38 PPP as a Long-Run Equilibrium Condition 39 Proportionality. Symmetry and Exclusiveness 42 The Effect of Different Weights. Non-Traded Goods and Transportation Costs 44 Misinterpretation of Cassel 47 3 The Covered Interest Parity Hypothesis 53 Introduction 53 The CIP Hypothesis: A Formal Exposition 55 The Role of Transaction Costs 58 Less Than Infinite Elasticities 63 Capital Market Imperfections 65 Political Risk 67 Capital Controls 68 Data Imperfections 69 The Role of Speculation 69 The Effect of Taxes 72 Default Risk 73 VII viii Contents Fisherian Expectations 74 The Role of Uncertainty 75 The Role of News 76 4 Uncovered Interest Parity and the Efficient Market Hypothesis 77 Introduction 77 The UIP Hypothesis 78 The Simple Efficiency Hypothesis 79 The General Efficiency Hypothesis 81 Rationalising the Failure of Unbiased Efficiency 82 Some Sources of Bias 89 5 Real Interest Parity and the Fisher Hypothesis 94 Introduction 94 The RIP Hypothesis 95 The Stability of the Fisher Closed Condition 97 Measurement of the Expected Inflation Rate 98 Allowing for Other Factors 101 The Choice of Interest Rate 103 Overlapping vs Non-Overlapping Data 104 The Choice of the Price Index 105 6 International Parity Conditions in a Cointegration Framework 107 The Basic Idea 107 Historical Review and the Building Blocks 113 Statistical Background 118 The Random Walk Model 119 Stationarity 121 Deterministic and Stochastic Trends 122 Short-Memory and Long-Memory Series 132 The Order of Integration 133 Cointegrated Variables 134 Implications for Conventional Econometric Techniques 139 Cointegration Analysis: The Pros and Cons 139 7 Testing for Stationarity and Unit Root 143 Introduction 143 The Dickey-Fuller Test 144 The Phillips-Perron Test 148 Contents IX The Sims Bayesian Test 151 The Variance Ratio (VR) Test 152 Testing for Seasonal Unit Roots 158 Testing for Unit Root: Further Remarks 165 8 Cointegration: Representation and Testing 167 More about the Cointegrating Regression 167 Testing for Cointegration: Residual-Based Tests 170 The Johansen Multivariate Method 174 Other Tests for Cointegration 179 Granger's Representation Theorem 181 Seasonal Cointegration and Error Correction Models 184 Cointegration in a Time-Varying Parameter Framework 186 Cointegration and Causality 187 Cointegration and Exogeneity 189 Cointegration and Simultaneous Equation Models 190 Cointegration and Non-Linearities 191 Cointegration and Dynamic Specification 192 Model Building with Integrated Variables: Summary 193 9 Purchasing Power Parity: Model Specification and Related Econometric Issues 195 Static Specifications 195 Dynamic Specifications 19S The Direction of Normalisation 202 Short-Run vs Long-Run Specifications 204 Structural Changes and Time-Varying Parameters 205 Allowing for Uncertainty 206 Testing PPP in Conjunction with UIP 208 Confusion between Absolute and Relative PPP 208 10 Purchasing Power Parity: The Empirical Evidence 213 Evidence from the Flexible Exchange Rates of the 1920s 213 Evidence from the post-Bretton Woods Flexible Exchange Rates 216 Exchange Rates of the EMS and Other European Countries 226 Other Exchange Rates 228 Long-Run Data 230 Testing the Augmented PPP 234 Concluding Remarks 236 x Contents 11 Covered Interest Parity: The Empirical Evidence 239 The Efficient Market Test 239 The Conventional Regression Test 239 Cointegration Analysis 241 The Dynamic Modelling Approach 242 National Currency vs Eurocurrency Assets 243 An Overview of the Empirical Evidence 244 Concluding Remarks 250 12 Uncovered Interest Parity and the Efficient Market Hypothesis: The Empirical Evidence 252 Conventional Regression Analysis 252 Error Orthogonality Tests 253 Tests Based on Vector Autoregression Analysis 254 Cointegration Analysis 254 Empirical Evidence on Nominal Interest Linkages 255 Empirical Evidence on Unbiased Efficiency: The Flexible Exchange Rates of the 1920s 257 Empirical Evidence on Unbiased Efficiency: The Testing Techniques 259 Empirical Evidence on Unbiased Efficiency: Other Aspects 270 Concluding Remarks 278 13 Real Interest Parity and the Fisher Hypothesis: The Empirical Evidence 280 Testing the FH: Conventional Regression Analysis 280 Testing the FH: Time-Varying Parametric Regression 284 Testing the FH: Serial Correlation and Orthogonality 285 Testing the FH: Cointegration Analysis 288 Testing the FH: Allowing for Controls and Taxes on Interest Income 291 Testing the FH: Allowing for the Phillips and Friedman Effects 293 Testing the FH: Final Remarks 294 Testing RIP: Conventional Regression Analysis 295 Testing RIP: Orthogonality Tests 298 Testing RIP: Cointegration Analysis 299 Testing RIP: Vector Autoregression Analysis 300 Testing RIP: The Kalman Filter Technique 301 Summary and Concluding Remarks 302 Contents xi 14 Concluding Remarks 304 Recapitulation 304 The Feldstein-Horioka Puzzle 306 Misconceptions about PPP 307 Where Do We Go From Here? 308 Notes 309 References 326 Author Index 360 Subject Index 367
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